Before discussing Spot vs future, let's discuss what spot market and futures markets are? and how do they operate? A spot market is a process of buying or selling and having the exchange settle immediately whereas, in the futures market, traders buy and sell contracts for delivery on a specified date in the future. Let’s see the spot market and futures market in detail.
What is a Spot Market?
In the spot market, the financial securities are traded for immediate delivery. Spot markets are most widely a physical market or a cash market because trades are exchanged for the asset immediately. The financial securities could be commodities, currencies, and other assets. In the spot market, the delivery of settlement price is immediately given from buyer to seller but the official transfer of funds between the buyer and seller may take time, such as T+2 in the stock market and most in most of the currency transactions both parties agree to the trade at the present instant. Transactions in the spot trading can take place on an exchange or over the counter. Near expiry trades of Futures contracts are also become spot trades since the expiring contract means that the buyer and seller will be exchanging cash for the underlying asset immediately.
What is a Futures Market?
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a pre-defined price at a specified time in the future. The buyer and seller of the contract are deciding to pay the price today for some asset or security that is to be delivered in the future. The market where futures contracts are being traded is called the futures market. Futures contracts are generally used by traders as a way to hedge other investments or to lock-in profits when trading in markets. Financial instruments in the futures markets are known as derivatives because their price is derived based on the underlying security in the cash market.
Spot Price v/s Future Price
The spot price is the current buying and selling price of the given asset such as a security, commodity, or currency in the marketplace for immediate delivery and a futures price is a predetermined price for future delivery of the asset.
Spot v/s Future
Now that you have a good understanding of spot and futures trading markets, let's look at some key differences between them.
Counter-party is the process in which, for each transaction, there is a buyer and a seller. Since future trades settle in the future the last thing you want is to have no one on the other side of the trade.
Future exchanges utilize two risk mitigation techniques to prevent this from happening:
Performance bond: To begin placing trades you need a performance bond or initial margin. Essentially it is the amount in your account to cover trade obligations.
Maintenance margin: The maintenance requirement is the minimum amount of money needed to cover all open positions. Now when it comes to the counter-party risk and spot market, the trading margin in the spot market is an upfront fee with the broker and is not related to counter-party risk.
Now in the futures market, the underlying asset has a specific settlement date in the future. If you are long in a futures contract you agreed to buy that contract on a specific date down the road. Conversely, if you are short you have entered an agreement to sell the contract on a future date. Now, this is where traders in the futures market come up ahead. When it comes to hedging against the risk traders in the future market can take this to their advantage by hedging against spot market traders.
Your ability to leverage is far greater in the future markets therefore you can purchase a few contracts but be able to hedge against a sizable spot market position.
The spot market is going to be the best for the traders that don't want to have to worry about time and they want to be able to buy and sell trades instantly and of course, have access to those settlement values instantly. The futures market is going to be for the traders that really want to hedge against the overall market and of course this can make you a reasonable return if you can predict the market correctly.
The spot market and the futures market have their pros and cons but make sure whatever market you choose best suits you as a trader because, in the end, it is the money you are investing.