What is spot trading?
A spot trade, also referred to as a spot transaction, can be defined as an acquisition or sale of an equity, foreign currency, commodity, or other financial asset which is due to be immediately delivered on a particular spot date.
A spot transaction means a physical exchange of a financial instrument with instant delivery. A spot market is also called a physical or cash market, because cash payments are processed with no delay.
Many financial assets quote a “spot price” and a “forward or futures price”, taking into account the value of the payment based on the time to maturity and interest rates.
Spot trading explained
Foreign exchange contracts are considered the most common type of spot trading and are often specified for delivery during two business days (i.e. T+2). The majority of other financial assets settle the next business day.
The spot foreign exchange market – Forex – trades electronically worldwide round the clock. Forex represents the largest global market with a daily trading volume of more than $6 trillion.
Financial assets traded on the spot market include not only forex pairs, but stocks and fixed-income instruments, such as treasury bills and bonds. Commodities also play an important role in spot markets, as investors open spot trades on energy, metals, agriculture and livestock.
The current price of a financial asset is called the spot price. It is the price at which a trader can buy or sell the instrument immediately. To create the spot price, sellers and buyers post their buy and sell orders on the market. If the market is liquid, the spot price can change in a matter of seconds, because outstanding orders are filled and new orders enter the marketplace.
Spot trade example
To provide a vivid spot trading example, let’s assume that a trader decided to go short (open a short spot trade) on EUR/USD pair. According to analysts’ predictions and the trader’s view, the euro will depreciate against the US dollar in the new future.
He decides to sell $10,000 at 1.070. If the euro plunges against the USD and he buys $10,000 at 1.020 to close the trade, the trader will get a profit of $500 ((1.070 – 1.020) x $10,000 = $500).
If the dollar’s weakening pushes the EUR up by 50 points and he decides to buy at 1.120 he will lose $500 ((1.120 – 1.070) x $10,000 = $500).
Types of spot trading market
There are two major types of spot markets: organised market exchanges and over-the-counter (OTC) markets.
Over-the-counter (OTC) is a marketplace where sellers and buyers meet to trade through a mutual bilateral agreement without a third-party supervisor to regulate the trade. Assets traded on the OTC market can differ in terms of price or quantity from the standards of traditional exchanges. OTC trades are mostly private and prices may be not disclosed.
Market exchange is an organised marketplace where sellers and buyers bid and trade available financial assets. Trading can be conducted on a trading floor or on an electronic trading platform. Electronic trading facilitated the trading process as prices are set instantaneously and a huge number of trades are made at the same time.
Exchanges can deal with several financial instruments or they may specialise on one specific type of asset. For example, the New York Stock exchange (NYSE) trades mostly in stocks, while Chicago Mercantile Exchange Group (CME) offers mostly commodities. Stock exchanges are regulated and all the trading procedures are standardised.