What is the Spot Forex Market?

What is the Spot Forex Market?

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The Spot Forex Market is also known as an “off-exchange” market or an over-the-counter OTC market, one of the largest and most liquid markets in the world that operates 24 hours a day, five days a week.

The reference made to the spot forex market being “off-exchange” refers to it being different from traditional markets. There is no central trading location or exchange as with other markets, making forex trading a decentralized activity that can be done from anywhere in the world.

How Spot Markets Work

One important thing to understand about the spot market is that it is not one single marketplace. Instead, it is an umbrella term used to describe a selection of cash markets where currencies and assets are exchanged in real-time.

These selections of markets are fast-paced, where the buying and selling of currencies happen congruently. These markets are also inherently active, liquid markets where supply and demand determine the price and value of assets.

One of the most well-known spot markets is the stock market, where investors can jump on at any given time during trading hours and exchange currencies for securities or sell their securities for coins.

The transaction occurs instantly, within a few seconds or minutes. Therefore, spot markets are typically referred to as the cash market. Much like the stock market, the spot forex market is the place where currencies can be exchanged instantly across borders.

This is also why the spot market is the first exposure to both investing and trading that novice traders have, as it is the easiest accessible and provides the perfect opportunity to gain experience in trading financial markets before moving on to the futures markets, bond markets, cryptocurrency market, commodity markets, and several other derivatives market.

Advantages of Spot Markets

  • Real-time prices of actual market prices
  • Active and liquid market
  • Can take immediate delivery
  • Flexible

The spot price is the current quote for immediate purchase, payment, and delivery of a particular financial instrument. This is vital as prices in the derivatives market, such as for futures and options, will depend on these values.

Spot markets are the most liquid and active for the same reasons. There are many commodity producers and consumers who will often engage in the spot market while they place hedges in the derivatives market.

The spot market is also known for being more flexible than the futures market as assets can be traded on lower volumes. In addition to this, the spot market is also more straightforward to understand, making it a good start for novice traders.

Disadvantages of Spot Markets

  • Not suited for hedging
  • Must take physical delivery of assets in some cases

One of the most significant disadvantages of the spot market is that buyers may have to take physical delivery of financial assets such as commodities. If you buy spot soybeans, you must take physical delivery of such.

Another disadvantage is that the spot market cannot be used to hedge against either production or the consumption of goods in the future, which means that derivatives markets are more suited for this type of trading.

What are the Types of Spot Markets?

Buying and selling in the spot market can happen through two distinctive ways, namely over-the-counter (OTC) or exchanges. 

  1. Over-the-Counter (OTC)

When there are trades that occur directly between two parties, the buyer and seller, it is called the over-the-counter or OTC market. The foreign exchange market, or forex market, is the largest, most liquid OTC market in the world, with a daily turnover of more than $6 trillion.

When there is an OTC transaction, the price may be based on a spot or a future price and/or date. In an OTC transaction, additionally, the terms do not need to be standardized, which means that they can be subjected to the discretion of either the buyer, seller, or both.

       2. Market Exchanges

Exchanges are inherently known for bringing dealers and traders together who buy and sell a range of financial instruments such as:

  • Commodities
  • Securities
  • Futures contracts
  • Options and several other financial instruments

The market exchange provides the current price as well as trading volume, which is available to traders who have access to the exchange, determined by all the orders provided by market participants.

The New York Stock Exchange (NYSE), which is an example of a formal exchange where retail traders and institutional and retail investors can buy and sell stocks for immediate delivery, is the perfect example of a spot market.

The Chicago Mercantile Exchange (CME), on the other hand, is an example of an exchange where traders and retail, and institutional investors can buy and sell futures contracts. Thus, CME is a futures market and not a spot market.

What is Spot Price?

The spot price is a term that refers to the current price of a specific asset. In spot markets, this price will change over a few seconds and minutes. Whenever you choose to buy the asset, you pay the spot price or the price of the asset as it currently is at the exact moment that you purchase it.

The spot price refers to the price at which the seller is willing to sell the asset in addition to that at which the buyer is willing to pay for it. The spot price represents free market supply as well as demand and valuation.

If there are no buyers, the price will fall, and if investors hold onto the asset, the price increases. Therefore, there are bearish and bullish market conditions present in the spot markets.

What are the Examples of Spot Markets?

  • Forex market
  • Stock market
  • Commodity markets

The forex market is the largest of all the spot markets with a daily trading volume of more than $6 trillion, followed by the stock market, which provides retail investors with the perfect opportunity to quickly buy and sell securities.

The commodity spot market offers traders the perfect platform to quickly buy commodities for delivery at the best current prices.

Are Spot Markets Good For Beginners?

Yes, the spot market is a good place to start for novice traders. Often when beginners start trading, they are given exposure to the spot forex and spot stock market, allowing them to quickly gain experience in trading foreign currency as well as stocks in spot transactions.

As a result of the high liquidity in spot markets, beginners have lower transaction costs, access to a variety of spot trading strategies, spot contracts, and a range of electronic trading options.

What is the Difference between the Spot Market and the Forward Market?

  • Transaction execution
  • Price
  • Locking exchange rates or hedging

The spot foreign exchange rate is that of a forex contract which is a transaction executed immediately and at most within two days. A forward foreign exchange contract is one where a certain amount of forex is either purchased/sold at a specified price for settlement and at a future date or within a set of future dates.

In the spot market, the spot rate refers to the price that the buyer expects to pay for forex in another currency, while with a forward forex transaction, the contracts can lock in a currency rate in anticipation that it will increase in the future.

The spot market and spot transactions are used for immediate requirements, for example, property purchases, deposits, deposits on cards, and so on. Traders can purchase a spot contract to lock the exchange rate on a forex pair in the future, or, for a modest fee, the trader can purchase a forward contract to lock in a future rate.

What is the Difference between the Spot Market and the Futures Market?

The key differences between the spot and futures market involve the following:

  • Counterparty risk
  • Settlement Period
  • Hedging against Risk
  • The trading of commodities
  • The prices
  • Ability to use the leverage 

The first key difference between the spot and futures market is counterparty risk. The counterparty refers to the process where there is a buyer and seller for each transaction.

When considering that futures are only settled in the future, there is always a risk that there may not be a counterparty at the other side of the trade when the date for settlement arises. 

The futures market uses two types of risk management techniques to prevent this from happening, namely performance bonds and a maintenance margin. To start placing trades, a performance bond or initial margin is needed. This is the cash that will cover trade obligations.

The maintenance requirement is a minimum amount of capital that will cover open positions, and it is seen as collateral if anything goes wrong with the trade.

The next key difference refers to the trade settlement period. For most spot markets, there is a settlement time that can either be immediate or up to two days, while in futures markets, there is a specific settlement date in the future.

Another key difference refers to hedging against risk, and this is where many retail traders prefer to use the futures market to hedge against the spot markets. The ability to use leverage in the futures market is greater than in the spot markets.

This allows traders to purchase futures contracts and prevent any large moves against them, risking a significant amount of capital.

The fourth key difference is that futures are inherently better for commodity trading. It allows traders to purchase a large number of commodities without opening a significant cash position and taking immediate delivery of the physical asset.

Another difference refers to the price difference between the future and spot markets. This is because futures prices have to carry costs as well as returns. 

Even though futures prices are settled daily, market-to-market, the price on these contracts will differ significantly from the underlying spot or cash market.

When traders hold a futures contract, they can expect interests, financing costs, and storage costs, to only name a few. There are also carrying returns to consider, which are dividends and bonuses which are paid out during the time that the trader has ownership of the commodity contract.

There are lower transaction costs involved with spot markets as a result of the high liquidity and fast-paced trading environment.

Lastly, the key difference between the spot and futures market revolves around the ability to use leverage. While some spot markets such as forex OTC can be leveraged, how margin and leverage work in these markets is vastly different.

In the futures market, each contract controls a certain number of units of an underlying asset or commodity. When trading commodities, traders must post an initial margin, or the performance bond, which is the amount of money that must be committed to taking ownership of a contract.

Margin requirements in the futures market are much less than when compared to equities, with a typical 25% requirement across the board. Meanwhile, the spot market offers leverage anywhere from 1:30 up to 1:3000 and more for major currencies.