3. What are spot trading and futures trading?
What is Spot Trading
This refers to transactions that take place on the spot markets, where buyers and sellers need to deliver goods immediately or within a few days after the closing deal.
In mature financial markets, most spot transactions generally implement the so-called “T+2” settlement. For instance, stock trading is mostly settled within two days after the transaction. However, spot trading does not necessarily have to take place at a specific time or place, and transactions in markets occurring off-exchange, are called OTC (Over-the-Counter).
These transactions are when buyers and sellers negotiate without going through an exchange or any other intermediaries. OTC transactions do not need to be processed through a central exchange floor like the stock market. A very good example of OTC trading is the Spot gold market.
To put it simply, spot trading is the most traditional and direct way of trading. Just like what happens in a bazaar or souk.
Related Article: What is OTC?
What is Futures Trading
This is the counterpart of spot trading, and futures are also developed on the basis of spot trading. Futures trading is when the buyer and seller agree to buy and sell a certain asset or commodity with a specific quantity and quality at a certain time and place in the future according to the contract terms and transaction price.
Most of the early players in futures markets were producers, wholesalers and retailers of certain commodities. The trade originated in the Japanese rice market in the 16th century and has since spread to the world.
Due to the uncontrollable supply of commodities (including man-made, natural, economic environment, etc.), the price of commodities is prone to fluctuations. Buyers and sellers of some commodities want to lock the future prices as a hedge against future fluctuations, which is the original intention of futures trading.
Because Futures markets not only facilitate the business of all parties involved but also effectively balance the unstable supply and demand in the market, helping to prevent unnecessary losses to buyers or sellers caused by volatile prices.
Hedging/arbitrage carries out through spot and futures markets.
Some Examples of Spot and Futures Trading
For instance, Merchant A holds large amounts of euros and is not expected to need to use them for a year. If the spot EUR/USD exchange rate is 1.3 and the futures price is 1.28 after 12 months, merchant A could sell. By buying the euro after 12 months at 1.28 to carry out forward arbitrage and make a profit.
For instance, Merchant B holds a large amount of corn because of the harvest and is worrying about its lifespan.
Corn has limited storage time but by using the spot market, selling and buying crops in advance is possible. Ensuring future supply, Merchant B can also buy corn to be delivered several months later using the futures market.
In conclusion, because the spot price and futures price belong to two different markets, they are technically different terms.
Next Article: 4. What is OTC?
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