Spot Market | Definition, Examples, Differences From Futures Market

According to the Oxford dictionary, a market is an area and occasion where people buy and sell goods.^[1] Markets come in a vast array of types, specifically financial and physical. In this article, we'll break down what a spot market is, what it does and how it differs from derivatives markets.

What Is A Spot Market?

A spot market is a space where securities, financial instruments, or commodities are exchanged directly. At a spot market, the delivery of assets is made immediately upon payment. Due to the rapid timeline of trade, the spot market is often referred to as the cash market.

Within the realm of contemporary finance, spot markets conduct business primarily in an over-the-counter (OTC) capacity. Commonly traded spot assets include currencies, commodities and shares. Among the most popular spot asset classes are metals such as gold and silver. However, energies such as crude oil and natural gas also garner significant attention.

Spot trades are executed in a similar fashion as in any other financial market. Essentially, a buyer compensates a seller in return for an asset. Upon the buyer committing to pay the spot price, the seller produces the underlying asset. Once the funds transfer finishes, physical delivery commences to complete the transaction.

Examples Of Spot Market Trading

Let's take a quick look at two spot market trading examples.

Gold

To illustrate spot market trading functionality, assume that Trader A is interested in acquiring gold. Their first step is to find a physical or online dealer that sells gold bars, coins or ingots. A few of the largest online vendors are JMBullion, SD Bullion, and the American Precious Metals Exchange (APMEX).^[2]

After finding a dealer, all Trader A has to do is pay the dealer the current spot market price for bullion. Then, the dealer makes a physical delivery, and the transaction is complete.

Forex

Another example of spot market transactions occurs on the global foreign exchange market (forex). On the forex market, participants buy and sell different quantities of currencies in the hopes of benefiting from price fluctuations. The forex is a massive OTC market, servicing upwards of US$5 trillion in volume per day.^[3]

When a trader buys or sells currencies on the forex market, they are paying or receiving spot market prices. This spot price, or spot rate, is put forth by the forex broker; it represents an average exchange rate for a currency pair.

For instance, let's say that Trader A is interested in buying one lot of the euro (EUR) and US dollar (USD) currency pair. If the current market price is 1.0200, then Trader A will pay 1.0200 for the exchange. Trader A's account will be debited for the purchase and a new long position will open in real-time. Transactions are immediate per the electronic trading platform.

Spot Vs Futures Trading

One of the greatest misconceptions in the financial arena is the idea that the spot and futures markets are the same. This assertion is categorically false; there are several key differences between the two including tradability, settlement and pricing.

Tradability

Trading spot and futures markets are two very different disciplines. In spot, traders are able to visit a physical market to buy or sell desired goods. Or, business may be done online (forex) with transactions being conducted immediately.

Futures contracts are financial derivatives traded through a centralised exchange. In order to buy or sell these products, one must have a seat at the exchange or work with a brokerage service that has exchange access. An example of such a venue is the world's largest futures marketplace, the Chicago Mercantile Exchange (CME).

Generally, there are lower barriers to entry for engaging the spot markets. Trading futures can be more capital intensive and require intermediary service suites.

Settlement

A futures contract is a legally binding agreement that specifies the exchange of an underlying asset at some later date. Futures contracts are subject to expiry, defined by settlement procedures. On the expiration date, the futures contract is officially settled between buyers and sellers. Once settlement is completed, the futures contract becomes untradeable.

As mentioned earlier, spot trades are subject to instantaneous settlement. There is no lag time in a spot trade; upon purchase, there is an immediate delivery of assets. For futures, contracts may be settled days, weeks, months, or years in the future.

Pricing

It's important to know that spot prices and futures prices are not the same. Here's a brief look at each:

• Spot Price: An asset's spot price is the current price at which said asset may be bought or sold at a particular place and time.^[4] On online platforms, spot price is often an "average" offered by liquidity providers, not a single vendor.
• Futures Contract Price: Futures contracts are priced with their expiration date in mind. The current contract price represents the asset's price on the settlement date. Given this structure, the futures markets are renowned for their uncertainty and volatility.

The difference between the spot price and future price of an asset is called the spread. It represents the discrepancy between what an asset is worth today and what it is expected to be worth at some future point in time.

One prominent example of the spot/futures spread occurred in the crude oil markets in April 2020. The global COVID-19 shutdown prompted a supply glut of oil that placed an emphasis on storage capacity. Subsequently, the price of Cushing, Oklahoma spot crude oil plunged to US$-36.98 per barrel^[5] while deferred month CME WTI futures contracts held their value well above US$0.00.

Summary

A spot market is a venue where assets are bought and sold. Payments and deliveries are immediate, making spot trading an instantaneous form of commerce. Many asset classes are traded on spot markets including currencies, commodities and other securities.

Spot market trading is very different from trading derivatives markets such as futures. Key discrepancies are present in the settlement procedures, tradability and asset pricing. Ultimately, it's up to the individual to decide whether or not spot trading is a suitable means of engaging the financial markets.