Spot Market

What Is a Spot Market?

The spot market is a public financial market where assets like commodities, stocks, currency, and other financial securities are exchanged between buyers and sellers. Financial securities are exchanged immediately for cash. The spot price is the price buyers or sellers are willing to pay or receive.

In this market, immediate settlement of securities takes place. It is also known as the liquid, cash, or physical market because cash payments are settled immediately, and respective assets are exchanged. 

While the payment and delivery of securities occur immediately, the settlement process may take some time. Depending on the trading venue, it is further classified into two categories:

1. Over-the-counter
2. Exchange-traded 

Generally, it is considered more transparent and liquid than the futures market.

Assets Traded on Spot Markets

There are spot markets for various securities like stocks (shares), bonds, treasury bills, currency (forex), and commodities. These securities must meet specific standards in terms of quality and quantity to trade in the spot market.

Commodity markets include various metal, agricultural, and energy products such as oil, natural gas, coffee, tea, cotton, gold, and silver. Crude oil is the most traded commodity.

The shares (equity) markets bring together buyers and sellers in a market where prices and volume are determined by demand and supply. 

Transactions are highly standardized to trade efficiently in the markets without any bias. The foreign exchange (forex) is the world's biggest and most liquid market.

While forex markets exist in every country, London is recognized as the world's largest forex market today, according to Reuters and City Asset Management.

How Spot Markets Work

While securities are settled immediately in the spot market, exchanges generally take two days for settlement. The contract between the buyer and seller of the commodity is settled on the spot at the current market price and quantity.  

This differs from futures and forward markets, where delivery of the actual assets occurs at a future date. The contract is entered into today, but settlement takes place in the future. The time taken for the delivery of securities varies depending on the country.

Although the formal transfer of funds may occur later, such as within T+2 days in the stock market and in many currency transactions, both parties commit to the trade instantly upon agreement.

In contrast, non-spot or futures transactions involve agreeing on a price at present, with the delivery and fund transfer scheduled for a later date.

For example, assume person A wants to purchase 5,000 shares from person B at a market value per share of $100.

He will bid on these shares through a spot market exchange, and the total amount of $500,000 will be debited from A's account. The delivery of shares will take place, at most, two days after the transaction.

Spot Market And Exchanges

An exchange is a centralized marketplace for the trading of financial securities. Trading occurs transparently through a centralized method. It is also known as an organized market exchange.

Trading occurs on an electronic platform where participants, both buyers and sellers, interact through brokers, also known as market makers, after opening their Demat accounts. All assets adhere to exchange standards.

Trades executed through an exchange are less risky than those carried out over the counter due to transparency and lower chances of payment defaults. Security prices fluctuate based on supply and demand.

For example, the Shanghai Gold Exchange (SGE) is the world's largest physical spot exchange. Some other examples of organized market exchanges are the New York Stock Exchange (NYSE) for the American market and the Indonesia Stock Exchange for the Indonesian market. 

Spot Market And Over-The-Counter

The over-the-counter (OTC) market is decentralized, with no central authority. Trade occurs directly between buyers and sellers or, in some cases, with the assistance of a mediator known as a dealer who facilitates the transaction for both parties.

Both buyers and sellers negotiate prices and conduct transactions immediately. Often, OTC prices are not publicly disclosed due to the private nature of the transactions. It is riskier for several reasons, including:

1. There is no transparency in the system
2. There are high chances of default
3. Assets traded lack standardization in terms of quality, quantity, and pricing

Advantages and disadvantages Of Spot Market

The advantages and disadvantages of the spot market are as follows: 

Advantages

The advantages are:

1. Trading in cash markets, unlike futures markets, does not require a minimum capital investment
2. Transactions are quick and settled in a short period
3. Volume is not fixed
4. Easy and less time-consuming
5. It is more flexible and liquid than the futures market
6. Transactions can happen in lower volumes
7. Immediate delivery of goods reduces the risk and possibility of defaults
8. It provides transparency and determines the fair value of the asset
9. Buyers can hold the asset until they find a better deal

Disadvantages

The disadvantages are:

1. It is not suitable for hedging against consumer goods in the future
2. Due to excess volatility in certain financial assets, investors tend to purchase them at a price higher than market value; therefore, it can sometimes be riskier while trading in the cash market
3. The interest rates of financial markets are affected by the default risk of the counterparty
4. Due to market makers' lack of liquidity and solvency, forex trading can sometimes be riskier
5. Immediate settlement of goods can sometimes complicate the process

Managing Risk in Spot Markets

A trader can manage their risk while trading in this market by keeping specific points in mind, including: 

1. Be regular with reading newspapers and periodicals 

Traders must habitually read newspapers daily to get updated with current news. This will help them know about the various happenings in the market that would directly/indirectly affect the price of certain financial assets they are trading. 

Trading without considering current market scenarios can be unfavorable for investors.

2. Manage emotions 

This is known as behavioral finance, where people often make decisions based on emotions, perceptions, and assumptions. It includes fear of loss, greed, self-doubt, and overconfidence.

A strong understanding and knowledge of finance and a proper strategy can help reduce behavioral biases. 

3. Understanding the market 

A proper understanding of financial markets is a prerequisite for trading in the cash market. Traders should know about taxation policy, settlement processes, rules, and regulations. 

They should also know the market trend, participants' behavior, and any policies affecting price. While fundamental variables influence prices, a deeper understanding of markets can contribute to better results.

4. Create your trading strategy 

This is the last step; every trader should create their trading strategy. 

It can be a combination of candlestick patterns and technical indicators or looking at fundamental factors like the news, accounting ratios, and a company's financial statements.

No matter what it is, it should ensure investors can make better decisions about whether they want to hold, buy, or sell. It also helps to determine the entry and exit points of a trade. Using stop loss and limit orders can help investors make better trades.  

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

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