Comprehensive Analysis of the Spot Market: Mechanics and Strategies

This report provides a comprehensive analysis of the spot market, a crucial component of the financial landscape where financial instruments like commodities, currencies, and securities are traded for immediate delivery. It details how spot markets function, emphasizing the immediate exchange of cash for assets, in contrast to futures contracts. The report defines the spot price and explains the roles of exchanges and over-the-counter (OTC) markets in facilitating spot trades. It includes examples, such as foreign exchange transactions and stock market trades, to illustrate spot market operations. Furthermore, the report outlines the advantages and disadvantages of spot markets, including real-time pricing and liquidity versus the need for physical delivery and limitations in hedging. It concludes with a discussion on managing risks in the spot market, emphasizing the importance of understanding the market, developing trading strategies, managing emotions, and staying informed about current events. The report also differentiates between spot and forward/futures markets, highlighting their distinct characteristics and uses.

SPOT MARKET
What Is a Spot Market?
The spot market is where financial instruments, such as commodities, currencies, and
securities, are traded for immediate delivery. Delivery is the exchange of cash for the
financial instrument. A futures contract, on the other hand, is based on the delivery of
the underlying asset at a future date.
Exchanges and over-the-counter (OTC) markets may provide spot trading and/or
futures trading.
Spot Market
How Spot Markets Work
Spot markets are also referred to as “physical markets” or “cash markets” because
trades are swapped for the asset effectively immediately. While the official transfer of
funds between the buyer and seller may take time, such as T+2 in the stock market and
in most currency transactions, both parties agree to the trade “right now.” A non-spot, or
futures transaction, is agreeing to a price now, but delivery and transfer of funds will
take place at a later date.
Futures trades in contracts that are about to expire are also sometimes called spot
trades since the expiring contract means that the buyer and seller will be exchanging
cash for the underlying asset immediately.
Spot Price
The current price of a financial instrument is called the spot price. It is the price at which
an instrument can be sold or bought immediately. Buyers and sellers create the spot
price by posting their buy and sell orders. In liquid markets, the spot price may change
by the second, as orders get filled and new ones enter the marketplace.
The word "spot" comes from the phrase "on the spot", where in these markets you can
purchase an asset on the spot.
Spot Market and Exchanges
Exchanges bring together dealers and traders who buy and sell commodities, securities,
futures, options, and other financial instruments. Based on all the orders provided by
participants, the exchange provides the current price and volume available to traders
with access to the exchange.
 The New York Stock Exchange (NYSE) is an example of an exchange where
traders buy and sell stocks for immediate delivery. This is a spot market.
 The Chicago Mercantile Exchange (CME) is an example of an exchange where
traders buy and sell futures contracts. This is a futures market and not a spot
market.

Spot Market and Over-the-Counter
Trades that occur directly between a buyer and seller are called over-the-
counter (OTC). A centralized exchange does not facilitate these trades. The foreign
exchange market (or forex market) is the world's largest OTC market with an average
daily turnover of $5 trillion.
In an OTC transaction, the price can be either based on a spot or a future price/date. In
an OTC transaction the terms are not necessarily standardized, and therefore, may be
subject to the discretion of the buyer and/or seller. As with exchanges, OTC stock
transactions are typically spot trades, while futures or forward transactions are often not
spot.
Example of a Spot Market
Let’s say an online furniture store in Germany offers a 30% discount to all international
customers who pay within five business days after placing an order.
Danielle, who operates an online furniture business in the United States, sees the offer
and decides to purchase $10,000 worth of tables from the online store. Since she needs
to buy euros for (almost) immediate delivery and is happy with the current
EUR/USD exchange rate of 1.1233, Danielle executes a foreign exchange transaction
at the spot price to buy the equivalent of $10,000 in euros, which works out to be
€8,902.34 ($10,000/1.1233). The spot transaction has a settlement date of T+2, so
Danielle receives her euros in two days and settles her account to receive the 30%
discount.
Advantages and Disadvantages of Spot Markets
The spot price is the current quote for immediate purchase, payment, and delivery of a
particular commodity. This means that it is incredibly important since prices in
derivatives markets such as for futures and options will be inevitably based on these
values. Spot markets also tend to be incredibly liquid and active for this reason.
Commodity producers and consumers will engage in the spot market and then hedge in
the derivatives market.
A disadvantage of the spot market, however, is taking delivery of the physical
commodity. If you buy spot pork bellies, you now own some live hogs. While a meat
processing plant may desire this, a speculator probably does not. Another downside is
that spot markets cannot be used effectively to hedge against the production or
consumption of goods in the future, which is where derivatives markets are better-
suited.
Pros
 Real-time prices of actual market prices
 Active and liquid markets
 Can take immediate delivery if desired
Cons
 Must take physical delivery in many cases
 Not suited for hedging

Spot Market FAQs
Advantages of Spot Markets
 Spot markets facilitate trading in a transparent environment,
where transactions occur at prevailing prices that are public
information and known to all parties. Basically, it is easier to
execute spot market contracts.
 Traders in spot markets can hold and find a better deal if they
are not satisfied with current prices and terms.
 Trades are done and completed on the spot.
 There may be no minimum capital requirements in spot market
transactions compared to some contracts on the futures
market that have minimum investment amounts for a single
contract.
Disadvantages of Spot Markets
 Due to the volatility of some financial instruments and
commodities, investors can buy on the spot at inflated prices
before assets find their “true price.” Hence, trading on the spot
market can present significant risks, especially for volatile
assets.

 There may be no recourse if a party notices some irregularities
in the trade after the spot market transaction is concluded.
 There is usually a lack of planning in spot trades, as opposed to
forwards and futures trading where parties agree on
settlement and delivery at a future date.
 The spot market is not flexible in terms of timing, as parties
will have to handle physical delivery on the spot.
 The interest rate spot market is affected by counterparty
default risk.
 Currency trading in spot markets is prone to counterparty risk
due to the solvency of the market maker.
Managing Risk in Spot Markets
1. Understand the market
Traders and investors need to understand the spot market where
they intend to transact. It means understanding the demand and
supply function, price discovery mechanism, trading terms, and
jargon of the spot market. In addition, traders need to be familiar
with the nature of other market participants, as well as the
regulatory structure of a spot market exchange.
In OTC spot markets, participants should evaluate the counterparty
to reduce counterparty default risk. By understanding the
mechanics of the market, it is easier to mitigate spot risks that may
emerge.
2. Develop a trading strategy
It is crucial for parties that trade in the spot market to adopt a
trading strategy before they decide to transact. Traders should
determine their own entry and exit points on specific assets before a
position is opened.
The use of price limits and price floors and the ability to detect risk
on a trade or counterparty instantly are other strategies that can be
employed. Using stops and limits will assist a trader to be more
efficient in deciding whether to proceed with a trade, hold and wait

or disengage the trade. Various stops and limits, such as the
following, are helpful:
Limit order: Closes your position once the price breaches your
chosen level.
Normal stop: Position is closed automatically if the market moves
adversely against your position.
Guaranteed stop: Closes position at exactly the specified price,
which eliminates the risk of slippage.
Trailing stop: Follows a positive price movement and closes if the
price begins to move against the target position.
3. Manage emotions
The volatility of financial markets can affect emotions when trading
in spot markets. It is, therefore, important to manage these
emotions to ensure a successful trade. Examples of emotions that
can interfere with trading include fear, doubt, greed, anxiety, and
temptation. Such emotions can cloud judgment and compromise
decision making, which can result in an adverse outcome of the
trade.
4. Be up-to-date on current events and news
It is also critical to be up-to-date with current news and happenings
on issues that affect the instruments or commodities traded on spot
markets, particularly where an investor is planning to make a trade.
Paying attention to market sentiment, keeping abreast of economic
and financial news, and paying attention to political and regulatory
announcements are all key matters for an investor in the spot
market. Any news that affects the price of the target asset should be
considered when making a spot trade decision.
What Does Spot Market Mean?
Spot markets trade commodities or other assets for immediate (or very near-term)
delivery. The word "spot" refers to the trade and receipt of the good being made "on the
spot".

What Are Examples of Spot Markets?
Many commodities have active spot markets, where physical spot commodities are
bought and sold in real-time for cash. Foreign exchange (FX) also has spot currencies
markets where the underlying currencies are physically exchanged following the
settlement date. Delivery usually occurs within 2 days after execution as it generally
takes 2 days to transfer funds between bank accounts. Stock markets can also be
thought of as spot markets, with shares of companies changing hands in real-time.
What Is a Spot and Forward Market?
A spot market is where spot commodities or other assets like currencies are traded for
immediate delivery for cash. A forward market instead involves the trading of futures
contracts (read on to the following question for more on this).
What Is the Difference Between Spot Markets and Futures Markets?
Forwards and futures are derivatives contracts that use the spot market as the
underlying asset. These are contracts that give the owner control of the underlying at
some point in the future, for a price agreed upon today. Only when the contracts expire
would physical delivery of the commodity or other asset take place, and often traders
will roll over or close out their contracts in order to avoid making or taking delivery
altogether. Forwards and futures are generically the same, except that forwards are
customizable and trade over-the-counter (OTC), whereas futures are standardized and
traded on exchanges.
References:
SPOT MARKET, SMITH, TIM; March 15, 2021, (Online) Investopedia.com
SPOT MARKET, Corporate Finance Institute, August 25, 2021, (Online) www.cfi.com