Introduction
Spot trades are a lot more common than most people think. For instance, it happens when someone exchanges their local currency for another through a forex transaction.
Or when a person goes to an exchange to buy their favourite cryptocurrency (check out our piece comparing the two instruments here).
As you can see, we can be spot traders across many capital markets. Here, we’ll look at the spot trading meaning in more detail.
What is spot trading?
Spot trading refers to trading a financial instrument for instant settlement at the current or spot price. So, in a nutshell, everything happens ‘on the spot’ without any future references. In many cases, this type of trading involves physical delivery or ownership of the asset in question.
For instance, crypto spot trading means owning the actual coin from an exchange you keep in a designated wallet.
In the case of forex, it would be receiving real currencies. As a crude example, if you went with US dollars to get euros at a forex dealer, you would obtain euros in cash. This, of course, can happen electronically, but the point is:
- Spot trading accounts for the instrument’s current price, with the immediate transfer of funds.
- You usually take ownership of that asset, which you can decide to keep or sell later.
Spot trading is different from futures trading (more on this later), where the delivery of the asset only happens at a later price and date.
Another critical component of spot trading is that you own the asset at its full value without leverage or margin (we go into the differences between the spot trading vs margin trading here).
Of course, there are many spot markets:
Now let’s look at the types of spot trading.
Types of spot trading
We broadly classify spot trading into two types: OTC (over-the-counter) and exchange-based:
- OTC: Over-the-counter describes a system where trading happens without an exchange. It consists of brokers that connect buyers and sellers on a private platform. Therefore, no third party (like an exchange) supervises everything that happens.
As a result, brokers have more freedom to offer less standardised products. Also, the spot prices through an OTC system are not exactly the same as those you’ll find with an exchange.
We use OTC when we’re not looking to own the financial asset in its physical form while looking to profit from it simultaneously. This is what we refer to as a derivative or CFD (contract for difference)
For instance, when you trade a forex pair from a broker, you don’t own the underlying currencies.
In the same context, spot trading crypto from a broker means that you have no digital possession of the coin.
However, you can make or lose money the same way if you exchange the same currencies through a bank (or buy the coin from an exchange).
Also, brokers are more accessible, and you can expect quicker settlement of your transactions.
- Exchange: This represents how we buy and sell most financial assets (e.g., crypto, stocks, bonds, options, commodities, futures). The main exception of a non-exchange traded instrument is FX, which remains decentralized or OTC-based.
An exchange is a system of an organised market where trading happens on a public platform.
In the old days, this platform was a trading floor or physical location. But nowadays, most trading happens electronically.
The core benefit of an exchange is transparency. Because everything is centralized, traders can access the same information on the same platform. This also means you can see how orders are executed at different levels through a matching engine called an order book.
So, effectively, traders are dealing with each other. On the other hand, your orders are matched with a private institution through the OTC system. This can result in several counterparty risks. Also, exchanges are always regulated, unlike OTC dealers.
Another point worth mentioning is that some markets have duality in how we can buy or sell them. For instance, we can trade bonds, stocks, crypto, commodities, futures and indices on exchanges and brokers.
Alternatives to spot trading
Needless to say, there are different avenues to spot trading, namely futures trading and options trading.
- Futures trading:
A future is a way of trading a market at a pre-determined value at a later expiry date. Traditionally, the purpose has always been to ‘lock in’ for something that will only be delivered in the future.
For instance, a corn producer may sell a corn futures contract now (after planting is done) for delivery in three months to secure a cheaper price. Yet, futures trading is also for speculators, not just hedgers.
This means there is no need to wait until expiry to close your position. Additionally, some traders may choose futures for features not available in the spot market.
For instance, leverage for crypto futures generally is higher than in the spot market; some FX traders can view useful exchange data they wouldn’t find with a FX broker.
- Options trading:
An option is a financial derivative where you have the right (but not the obligation) to buy or sell a specific market at a certain price and expiry date.
Simply put, you can buy or sell but aren’t obligated to hold what you’ve bought or sold. The only price you pay is a premium if your prediction is wrong.
Options trading is like wagering or betting the value of an asset will be below or above a certain level (the ‘strike price’) within a set time limit.
Traders may choose to focus only on options or trade the options and spot markets at the same time for hedging purposes. So, one may take a sell position on one and a buy position on the other.
Benefits of spot trading
Let’s explore the several reasons why people choose to become spot traders:
- Simplicity: The concept of spot is straightforward. Traders buy and sell at the immediate price with instant settlement, meaning there is no waiting. This is beneficial if you’re selling a market for a profit because you’re confident that the closing price is final.
The concept of spot trading is much simpler than futures trading since you don’t have to account for later events or periods.
- No leverage involved: This benefits more risk-averse investors or traders. Let’s look at a popular spot market like forex. FX has the highest margin rates across all instruments.
However, the failure rate is quite high because traders misuse the leverage, leading to substantial losses.
Yet, most spot trading is unleveraged. This doesn’t mean that you can lose money. But, the loss rate is slower, allowing you to remain in the market longer.
- Suitable for investing: This point extends from the last line. Most spot trading involves taking ownership of a financial asset. For example, buying stocks from an exchange or even buying gold or silver from a dealer.
When the market is in a downturn, you can withstand these periods without worrying about margin, which can wipe you out faster. Also, some people prefer owning actual assets instead of derivatives.
So, the spot market is suitable for this purpose. Yet, it is also a good fit for short-term trading when ownership isn’t necessary.
Drawbacks of spot trading
Of course, there are downsides to this trading style:
- Often needs more capital: In many cases, you need more money in your account for a spot trade. Again, this is due to the lack of leverage. Margin allows investors to trade larger positions with a smaller balance.
Without leverage, you need to have the full value of the position as capital. For instance, a standard lot on EUR/USD is generally worth $100 000. However, leverage can allow traders to trade the same position with as little as $1000 in their equity.
- Physical ownership: Of course, this doesn’t apply to all markets. Yet, it’s worth considering if you’re an investor looking to own actual assets, e.g., physical gold, bonds, coins, etc.
A physical asset will need extra care and attention. For instance, if you own gold, there are more costs involved in storage and insurance.
Consider another example. When you buy a cryptocurrency, you might need to consider a ‘cold’ wallet (a wallet not connected to the internet) to protect yourself against online threats. This understandably will cost you extra.
So, in many cases, trading derivatives in the spot market is a better and less tedious method.
Conclusion
To summarise, spot trading is the easiest way to trade a financial security because of the instant settlement. Moreover, it’s the most accessible method for the average investor.
But this is where the simplicity stops. Spot prices, like any markets, are driven by many variables that need to be studied.
Generally, because of the capital requirements, you may need to consider margin to increase your bottom line. Yet, ensure you understand the risks involved, so you don’t ‘lose your shirt.’
