What is a Spot Market?
A spot market is a financial market where financial instruments and commodities are traded for instantaneous delivery. Delivery refers to the physical exchange of a financial instrument or commodity with a cash consideration. The spot market is also known as the cash market or physical market because cash payments are processed immediately, and there is a physical exchange of assets.
Understanding Spot Markets
In a spot market, delivery and cash payment normally take place on the spot. However, in most organized markets, settlement – which is the transfer of cash and physical delivery of the instrument or commodity – normally takes 2 working days (i.e., T+2). Despite the T+2 settlement date, the contract between the buyer and seller is performed on the spot at the prevailing price and existing quantity.
It contrasts with forward and futures markets, where parties agree to trade at a forward/future price of the underlying asset, and delivery is also expected in the future. Therefore, as opposed to spot markets, forward/futures markets make a contract today, but settlement is expected in the future. Spot markets can exist wherever there is an infrastructure to carry out such a trade.
An example of a spot market trade is when an investor (Mr. Jones) wants to buy 1,000 IBM shares on the New York Stock Exchange (NYSE). He will contact his broker to buy the shares at the prevailing market price, say $117.60. The transfer of funds is completed immediately by the broker to the seller at a consideration of $117,600. Ownership of the shares is transferred to Mr. Jones as soon as the funds clear and are received by the seller.
Assets Traded on Spot Markets
Financial instruments traded on spot markets include equity, fixed-income instruments such as bonds and treasury bills, and foreign exchange. Commodities also dominate spot markets through the trading of energy, metals, agriculture, and livestock. Spot markets also trade in perishable and non-perishable commodities.
The foreign exchange market, where traders exchange various currencies, is one of the largest spot markets worldwide with a daily turnover in excess of $6 trillion, making it the world’s most actively traded asset.
Commodities are standardized in order to trade efficiently on spot markets. Crude oil is the most traded commodity. Recently, technology – such as bandwidth and mobile minutes – has been featured in spot markets with commodities.
Characteristics of Spot Markets
Certain features are associated with spot markets. Below are the most apparent:
- Transactions are settled at the ruling price known as the spot price or spot rate.
- Delivery of the asset takes place immediately or otherwise at T+2.
- Transfer of funds is instantaneous; otherwise, settlement can be at T+2.
The price on the spot market is the going price for a trade executed on the spot and is known as the spot price or the spot rate. Price is determined by buyers and sellers through an economic process of supply and demand.
Unlike the forward price – which is a function of the time value of money, yield curve, and/or storage costs – the spot price is largely a product of supply and demand function. Buyers and sellers need to agree to pay and receive the spot price for the standard quantity of assets on offer for a transaction to occur.
Types of Spot Markets
There two main types of spot markets – over-the-counter (OTC) and organized market exchange.
1. Over-the-Counter (OTC)
Over-the-counter (OTC) is a place where buyers and sellers meet to trade bilaterally through consensus. There is no third-party supervisor of a transaction or a central exchange institution to regulate the trade. Assets being traded may not be standardized in terms of quantity, price, or other terms, as is the norm on organized exchanges.
Hence, buyers and sellers negotiate all terms of trade and transact on the spot. Prices in OTC markets may not be published, as trades are largely private. The currency exchange market is the most active and widely known OTC market.
2. Market Exchanges
In an organized market exchange, buyers and sellers meet to bid and offer financial instruments and commodities available. Trading can be carried out on an electronic trading platform or a trading floor. Electronic trading platforms have made trading more efficient, where prices are determined instantaneously, given the large number of trades in some exchanges.
Exchanges deal in several financial instruments and commodities, or they may carve a niche on specific types of assets. Trading is usually completed through brokers of the exchange who act as the market makers. Assets traded on exchanges are standardized, as per the exchange standard.
There are likely to be minimum contract prices for assets being traded or in specific quantities and values. Prices are set through many buyers’ bids (prices offered to buy) and sellers’ offers (prices offered to sell). Spot prices can change every minute or even milliseconds.
Exchanges are regulated, where all procedures and trading are standardized. Examples of popular exchanges are the New York Stock Exchange (NYSE), which trades mostly in stocks, and the Chicago Mercantile Exchange Group, which trades mostly in commodities and offers trading in options and futures.
Advantages of Spot Markets
- Spot markets facilitate trading in a transparent environment, where transactions occur at prevailing prices that are public information and known to all parties. Basically, it is easier to execute spot market contracts.
- Traders in spot markets can hold and find a better deal if they are not satisfied with current prices and terms.
- Trades are done and completed on the spot.
- There may be no minimum capital requirements in spot market transactions compared to some contracts on the futures market that have minimum investment amounts for a single contract.
Disadvantages of Spot Markets
- Due to the volatility of some financial instruments and commodities, investors can buy on the spot at inflated prices before assets find their “true price.” Hence, trading on the spot market can present significant risks, especially for volatile assets.
- There may be no recourse if a party notices some irregularities in the trade after the spot market transaction is concluded.
- There is usually a lack of planning in spot trades, as opposed to forwards and futures trading where parties agree on settlement and delivery at a future date.
- The spot market is not flexible in terms of timing, as parties will have to handle physical delivery on the spot.
- The interest rate spot market is affected by counterparty default risk.
- Currency trading in spot markets is prone to counterparty risk due to the solvency of the market maker.
Managing Risk in Spot Markets
1. Understand the market
Traders and investors need to understand the spot market where they intend to transact. It means understanding the demand and supply function, price discovery mechanism, trading terms, and jargon of the spot market. In addition, traders need to be familiar with the nature of other market participants, as well as the regulatory structure of a spot market exchange.
In OTC spot markets, participants should evaluate the counterparty to reduce counterparty default risk. By understanding the mechanics of the market, it is easier to mitigate spot risks that may emerge.
2. Develop a trading strategy
It is crucial for parties that trade in the spot market to adopt a trading strategy before they decide to transact. Traders should determine their own entry and exit points on specific assets before a position is opened.
The use of price limits and price floors and the ability to detect risk on a trade or counterparty instantly are other strategies that can be employed. Using stops and limits will assist a trader to be more efficient in deciding whether to proceed with a trade, hold and wait or disengage the trade. Various stops and limits, such as the following, are helpful:
Limit order: Closes your position once the price breaches your chosen level.
Normal stop: Position is closed automatically if the market moves adversely against your position.
Guaranteed stop: Closes position at exactly the specified price, which eliminates the risk of slippage.
Trailing stop: Follows a positive price movement and closes if the price begins to move against the target position.
3. Manage emotions
The volatility of financial markets can affect emotions when trading in spot markets. It is, therefore, important to manage these emotions to ensure a successful trade. Examples of emotions that can interfere with trading include fear, doubt, greed, anxiety, and temptation. Such emotions can cloud judgment and compromise decision making, which can result in an adverse outcome of the trade.
4. Be up-to-date on current events and news
It is also critical to be up-to-date with current news and happenings on issues that affect the instruments or commodities traded on spot markets, particularly where an investor is planning to make a trade.
Paying attention to market sentiment, keeping abreast of economic and financial news, and paying attention to political and regulatory announcements are all key matters for an investor in the spot market. Any news that affects the price of the target asset should be considered when making a spot trade decision.
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