Spot Market

A public financial market where assets like commodities, stocks, currency, and other financial securities are exchanged between buyers and sellers.

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 delivered immediately with cash as consideration. The spot price is the price buyers/sellers are willing to pay/receive in the spot market.

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. 

Though the payment and delivery of securities take place immediately, exchanges take some time to process and settle.

Depending on where the trade takes place, it is further classified into two categories:

1. Over-the-counter

2. Exchange-traded 

It is more transparent and liquid than the futures market.

Financial assets of the spot market 

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 cash market.

Oil refineries

Commodity markets include various metal, agricultural, and energy products like 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 market (forex market) is the world's biggest and most liquid market. Its turnover is more than $7 trillion in a single trading day. 

Every country has forex markets, but according to Reuters and City Asset Management, London is today's world's largest forex market. 

mechanism

As securities are settled immediately in the cash 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 is dissimilar to the future and forward markets, where delivery of the actual assets happens 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 from country to country.

For example - Let's assume person A wants to purchase 5,000 shares from person B and the market value per share is $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, and the delivery of shares will take place, at most, two days after the transaction.

Types of spot markets

Depending upon where the trade takes place, it is classified into two types:

1. Over-The-Counter (OTC) 

2. Exchange-Traded

1. Exchange-Traded

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

Trading happens on an electronic platform where the participants (both buyers and sellers) have to open their Demat account (digital storage for securities) with the brokers of the respective exchange, also known as market makers. All the assets are standardized as per 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.

Securities prices are determined by the forces of demand and supply, which can change from second to second. 

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. 

2. Over-the-counter (OTC)

The OTC market is decentralized, with no central authority. Trade happens directly between buyers and sellers, or sometimes with the help of a mediator, known as a dealer, who helps both parties execute the trade.

Both buyers and sellers negotiate prices and transact on the spot. Mostly, OTC prices are not published because trade happens privately.

It is riskier for a multitude of reasons, including:

1. There is no transparency in the system

2. There are high chances of default

3. Assets traded are not standardized in terms of quality, quantity, and price 

Advantages and disadvantages 

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

Advantages 

1. While trading in cash markets, unlike futures markets, there is no minimum capital requirement. 

2. Transactions are quick and settled in a short period.

3. No fixed volume

4. Easy, 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 is more transparent and tells the fair value of the asset.

9. Buyers can hold the asset until they find a better deal.

Pros and Cons

Disadvantages

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. As there is an immediate settlement of goods, it sometimes makes the whole process a bit complicated.

How to manage risk in the spot market?

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

Risk

1. Be regular with reading newspapers and periodicals 

Traders must build a habit of reading 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. 

Trades are taken 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 the fear of losing, 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. As prices are determined by a handful of fundamental variables, a better understanding of markets will lead 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.  

Trading

Conclusion

The spot market is one of the essential components of the global capital markets. It aids the international circulation of money and maintains liquidity in the economy.

It supports price discovery, as the fair value of financial assets can be estimated with the help of the cash market. Settlement in exchanges takes place immediately, reducing the risk.  

Forex is the biggest and most liquid market in the world. In 2020, the global forex market was valued at $2.4 quadrillion. It is even bigger than the global stock market.

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Researched and Authored by Tanishq | LinkedIn 

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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