What is Spot Trade?
A spot trade, also referred to as a spot transaction, is when a trader makes a purchase on a financial instrument, commodity, or foreign currency on some specified date. Typically, a spot contract includes the physical delivery of the currency or instrument. A spot transaction takes into account the time value of share price payment. This time value changes based on the maturity and interest rates. In a spot trade with respect to foreign exchange, the rate at which the change is carried out is called the spot exchange rate. One can contrast futures trading with spot trading.
Understanding Spot Trading
Now that we understand the spot transaction definition, the most common spot transactions are foreign exchange spot contracts which are usually delivered within two business days (T+2). Alternatively, many other financial instruments tend to settle by the following business day. Forex markets or ‘spot foreign exchange markets’ trade electronically globally. Forex is the world’s largest market. Over $5 million is traded on Forex daily. In comparison, interest rates as well as commodity markets are much smaller.
A financial instrument’s current price is referred to as its spot price. This is the price at which the instrument can be sold or bought instantly. The spot price is created by sellers and buyers after they post their sell or buy orders. Spot prices change by the second in liquid markets since orders get filled instantaneously when new ones come into the marketplace. Bonds, options and most other interest rate products also trade for spot settlements on the following trading day.
Spot trading contracts are commonly seen between a company and a financial institution, or between two financial institutions themselves. In an interest rate swap, the near leg is typically for the spot date and often settles in two trading days. Oftentimes, commodities are also traded on exchanges, with the most common commodities being traded on the CME group and the New York Stock Exchange. Commodity trading, often, is carried out for future settlement where it is not delivered, and the contract is resold back to its respective exchange prior to its maturity. The gain or loss from this exchange is settled in liquid funds.
How Market Exchanges Work
Spot exchanges, as mentioned earlier include the New York Stock Exchange (NYSE) and the Chicago Mercantile Exchange (CME). Each of these exchanges brings together both traders and dealers who sell or buy securities, futures, commodities, options, and other types of financial instruments. The participants on the exchange place their orders for buying or selling securities at the spot price.
Based on all the orders provided on any given day, the exchange serves as a platform to offer the share’s current volume and price to the trades who have access to the exchange. On the New York Stock Exchange (NYSE) traders buy and/or sell stocks. NYSE is a pure spot market. On the other hand, CME or the Chicago Mercantile Exchange is a place where futures contracts are both bought and/or sold. Hence, CME is not a spot market but a futures market.
Market versus Over The Counter (OTC)
Spot markets like forex are publicly traded exchanges. However, centralised exchanges in the form of markets do not encapsulate all spot transactions ever. A spot transaction example can also be seen directly between buyer and seller. These are called over-the-counter spot trades. Unlike forex and other market trades, OTC transactions are decentralised.
In such transactions, the share price is either based on a future date/price or on the spot price. In an OTC transaction, the terms for the trade are not necessarily standardized. Hence, these transactions are usually subjected to the buyer’s and/or seller’s discretion. OTC stock transactions, similar to exchanges, are usually spot trades. Forward transactions or futures are often not spot transactions.
Spot markets are places where spot trading occurs wherein financial instruments are trade for immediate delivery. Assets eligible for a spot transaction quote a spot price — their current trading price — as well as a forward price — which will be their future trading price. Typically, spot transitions have a T+2 settlement time horizon. These transactions can take place over the counter in a decentralised manner or on publicly traded exchanges like the NYSE, forex, and CME.