The factor that differentiates spot trading from derivatives trading is that in the derivatives market, stock market prices are not ‘regulated’ immediately, unlike in a traditional spot market. Instead, two opposing parties will execute transactions under the contract, with a settlement at a future date (upon dissolution of the position).
What is spot trading?
A spot trade, also known as a spot transaction, is when a trader makes a purchase on a financial instrument, commodity or foreign currency on a particular date. Typically, a spot contract involves the physical delivery of the currency or instrument. A spot transaction takes into account the time value of the share price payment. This time value varies based on revenue and interest rates. In spot trading in relation to foreign exchange, the exchange rate at which the change is made is called the exchange rate. It is possible to differentiate between futures trading and spot trading.
The spot market, or also known as the “cash market” and the “physical market”, is a financial market where goods or financial instruments are sold in cash and delivered immediately. The spot market can be an organized market, stock exchange or over-the-counter.
The spot market is the opposite of the derivatives market where payment and delivery are supposed to be at a later date. Contracts purchased and sold in the cash market take effect immediately and delivery should be made within two business days of placing the trade order.
Spot market participants use it to purchase or sell physical goods, meaning a large portion of the players here are actually farmers or producers who need to re-inventory and so on. Investors who want to buy shares of a company also purchase them through spot markets.
For example, if you wanted to buy shares of XYZ and hold them immediately, you would go to the New York Stock Exchange or another stock exchange if the company met the requirements to be listed there. If not, the corporation’s shares will be traded without a prescription and you can still buy them in cash. If you want to buy gold in the spot market, you can go to a coin dealer and exchange cash for gold.
What is derivatives trading?
Derivatives are financial contracts that derive their value from an underlying asset. These can be stocks, indices, commodities, currencies, exchange rates or the interest rate. These financial instruments help you earn by betting on the future value of the underlying asset. So their value is derived from that of the underlying asset. This is why they are called ‘derivatives’.
A common type of currency derivative, futures, is legally binding agreements that require both parties to trade in a certain amount of securities. A pair of currencies or commodities against a currency such as the dollar – at a predetermined price, or ‘exchange rate’, at a certain point in the foreseeable future.
Investors can trade futures in two ways; Firstly, simply by owning the device on which they trade in the first place, or secondly by a brief decline and betting that their target security will decrease in value by the date of the contract settlement.
In this regard, it is possible to trade futures between investors for profit only without the underlying asset ever being physically transferred to the buyer (as long as trading closes before the deadline) – for example, most retailers would not know what to do with literal delivery of crude oil barrels. But will be able to profit by selling a contract for future supply of affordable oil with other interested parties in need of such inventory.
Longer-term tactic, strategically, futures contracts are usually traded in specific futures markets. Such arrangements are often backed by large corporations in order to hedge against market uncertainty – by “locking in” the price of a product actually given for an agreed period of time – and to protect themselves from sudden changes in global currency exchange rates.
Key difference between Spot Trading Vs Derivative Trading
There is another major difference between the activity in the derivatives market and the participation in the cash market – by holding a futures contract you are not necessarily obligated to physically receive or supply large stocks of goods such as gold, oil, copper, corn, etc. Traders enter the futures market primarily to speculate whether prices will rise or fall, or to hedge, instead of physically exchanging raw materials, which is the primary use of the spot market.
Futures contracts have become a major part of the financial markets precisely because neither the buyer nor the seller are obligated to accept or deliver the amount of goods or securities traded. But this raises the following question: Since the two counterparts made a deal with a maturity date, what happens on the due date and if we do not want to receive or send a physical delivery, how can we avoid it?
As futures approach maturity, their prices narrow the gap to the spot price of the underlying asset and become equal on the expiration date, a condition also known as convergence. It is very important that traders close their open positions to avoid taking the traded property.
Advantages and disadvantages of derivatives versus spot trading
In general, the more immediate and dynamic nature of spot currency allows you to trade a huge amount of different currencies and commodities at a higher liquidity level than derivative contracts. However, the variable variables involved – e.g. this means that it is also easier to get out if you are not careful.
In contrast, existing pricing negotiation arrangements in futures contracts mean that most (if not all) of your trading cost should be visible to you before you sign (the dotted line); The obvious crumb is that you are then bound by these specific terms for the duration of the contract.
Beginners in the trading game will likely find a spot currency, so it will be easier to deal with both categories; this is because it requires less initial capital to participate and exposes the trader to less long-term risk.
Some more experienced forex investors are able to take advantage of both types of trades at the same time – to engage in spot trades on a day-to-day basis, while maintaining a portfolio of futures contracts – allowing them to enjoy their benefits respectively; Consistency, but it is a worthy goal for avid traders to work towards it!
Thanks for reading; we hope you found this article by Drixx informative. Drixx is a next-level cryptocurrency derivatives exchange, offering its retail users to trade a variety of devices using a peer-to-peer matching engine. Users are able to instantly sign up, deposit and trade in our deep liquidity markets and our tight spread markets.