What is Spot Trading? How to Trade Spot MarketsMay 23, 2022
Spot trading is a good option for traders of all experience levels, as they are a relatively simple way to invest and trade. In fact, some of the world’s most popular markets, such as the Nasdaq or New York Stock Exchange (NYSE), are spot markets.
While you might be wondering what we mean by spot trading, you are probably more familiar with it than you think. In any case, let us take you through everything you need to know about this important aspect of market trading, including what they are, and how to trade on them.
What is Spot Trading?
Spot trading refers to the buying and selling of assets at the current market rate – also called the spot rate – for immediate delivery on a specified date. It involves the purchase or sale of a number of different securities, such as currencies, commodities, and other financial instruments.
It is a popular method used by day traders, as it allows them to open short-term positions featuring low spreads and no expiry date. Spot markets are also branded as cash – or physical – markets, because cash payments are processed immediately.
Traders are able to exchange assets at any time, which differs from non-spot trades, where certain agreements must be made before they take place. This means that spot trading is one of the fastest ways of completing a market transaction because, as opposed to futures markets, delivery is usually taken on the spot.
Although the contract between the buyer and the seller is performed instantly at the prevailing price and existing quantity, the physical delivery of the instrument or commodity can take up to two working days to come through, which is referred to as T+2 settlement date.
Types of Spot Markets
This is where market participants trade stocks, currencies, and commodities directly between two parties on a decentralised market, without the third-party supervision of a central exchange or other type of institution to regulate the transaction.
In this instance, traded assets may not be standardised in terms of quantity or price, while buyers and sellers negotiate all the key terms of trade, in order to conduct the transaction on the spot, in the most effective manner.
The most common OTC example is the foreign exchange, or forex, market, which determines the exchange rate for global currencies. It is the largest financial market in the world, comprising a global network of financial centres that operate 24 hours a day, five days a week.
Market exchanges bring together brokers and traders, who buy and sell a range of assets, including commodities, shares, futures, options, and other financial instruments together. The exchange offers the current price and volume available to traders, with access to the market, on the basis of all orders made by participants.
Minimum contract prices are likely to be in place for assets being traded or in specific quantities and values. These rates are usually set through many buyers’ bids – the prices offered to buy, and sellers’ offers – the prices offered to sell. Spot prices can change every minute, or even every second.
They are regulated and adhere to standardised trading procedures. In the US, the NYSE is an example of a spot market exchange, where traders can buy and sell stocks, whereas the Chicago Mercantile Exchange (CME) is a futures market exchange, where traders buy and sell futures contracts.
Advantages of Spot Trading
These markets form part of a transparent trading environment, as transactions can be made using prevailing prices that are in the public domain and known to all parties. This makes spot contracts easier to execute, as traders can use yesterday’s price to make a transaction today.
This type of trading does not normally require as much initial capital from an investor. This contrasts with the futures market, which tends to involve minimum investment amounts for a single contract, which can sometimes be a significant amount.
Traders have the ability to hold their investment and find a better deal, if they are not completely satisfied with current prices and terms on offer, while transactions can run on much lower volumes than the futures market.
Disadvantages of Spot Trading
Investors could be the victim of buying on the spot at inflated prices, i.e., before assets reach their true price. This is caused by the volatility of some financial instruments and commodities and can lead to a higher level of risk, especially in terms of profit margin.
Spot markets cannot be used as an effective way to hedge against the production or consumption of goods in the future, compared to the derivatives markets, which are far better-suited to this. This means that the financial risk in spot trading cannot be managed or mitigated as successfully.
There tends to be a distinct lack of planning in spot trading, when directly compared to forwards and futures trading, where parties agree on settlement and delivery at a defined future date, while the interest rate spot market can be affected by counterparty default risk.
Trading in spot markets is a straightforward way for traders of all abilities and experience types to buy and sell assets and other financial instruments. As an established method of conducting trades, it is popular among investors thanks to its relative simplicity.
Despite being mostly easy to understand, it is important to keep abreast of the finer details listed above, particularly in terms of being aware of the key advantages and disadvantages associated with spot trading.
Alongside getting to grips with the essential points, you should also consider building on your existing knowledge by brushing up on technical, fundamental, and sentiment analysis, as a means of improving your general trading abilities.