Spot vs Futures Trading [Complete Comparison]

    Spot vs Futures Trading

    What is Spot Trading?

    Introduction to spot trading

    A spot trade is when a trader buys a financial instrument, stock, or foreign currency. Also known as a spot transaction, the exchange happens on a particular date, and usually, the physical exchange of currency or financial instrument occurs on the spot.

    The share price amount of the spot transaction is determined by the time value of the share. As the share matures and the interest rate changes, the time value of the share changes too. The rate of transaction with respect to foreign exchange is called the spot exchange rate.

    A very common transaction, which is a foreign exchange contract, is done within 2 business days. Other spot transactions follow a similar trend. One of the famous and common spot tradings is Forex trading.

    What is Spot Price?

    A financial instrument can be sold or purchased on the spot at the spot price. The spot price is the current price of the financial instrument. The spot price is decided by the sellers and buyers after posting an order. In liquid markets, the spot price fluctuates and changes rapidly as new traders keep entering the market. The interest rate products are traded on the next day by spot settlements.

    Usually, 2 financial institutions or one financial institution and one company sign for spot trading. The interest rate swap on the near leg date mostly ends in 2 business days. In foreign exchange, the near leg is the date when you trade one currency for another at a decided rate and agree to trade those currencies at a later date. This later date is known as the far leg date.

    Commodities are also traded on spot trading, and the common commodity trading companies are CME Group and New York Stock Exchange. The process is a bit different here. This trading signs for a future settlement but doesn’t deliver it. Rather the contract is resold to the party before it matures. Liquid funds settle the loss and profit of these kinds of exchanges.

    What are Spot exchange marketplaces?

    Spot exchange marketplaces are over-the-counter (OTC) markets like the New York Stock Exchange. These exchanges are places where traders and dealers are brought together. They buy or sell commodities, securities, currencies, and other financial instruments. They offer prices and place orders for selling and buying at the spot price.

    Now the exchange makes a list of the orders placed to the eligible traders mentioning the share volume and prices. While the New York Stock Exchange is dedicated to spotting trade, exchanges like the Chicago Mercantile Exchange offer future contracts for selling and buying. CME is not a spot market.

    Over-the-Counter Transaction

    While spot markets are centralized and mostly operated by the exchange companies, over-the-counter transactions are decentralized and occur directly between the seller and the buyer.

    As the transaction is not centralized, the share price might be decided on the basis of the spot price or the future rate. Also, the terms and conditions of trading can be altered according to the convenience of the sellers and buyers. But in most cases, over-the-counter transactions occur according to the rules of spot trading.

    All in all, spot trading is one of the best financial instruments. The transaction is normally done within 2 business days. The price of the asset can be based on the spot price (current price) or the future price. The trading can be centralized by publicly traded exchanges or decentralized over-the-counter trading can occur too.

    What is Futures Trading?

    Futures trading depends on derivatives, which are financial contracts that determine their price from the price movements and changes of another financial instrument. Basically, it compares the price of others to decide a price for itself.

    Now let us talk about the concept of futures trading. It is a type of financial process where a contract is made between a buyer and a seller. But it is just the opposite of spot trading. The trading would be kept on hold for the future. The buyer would be buying the derivative in the future at a specified time.

    The profit and loss of the trader now depend on the price fluctuation of the share. If the price of the share goes up by the predetermined date, then the trader will earn a profit. If the price drops, then it would be a loss for the seller and profitable for the buyer. Futures trading, therefore, uses the opportunity of price fluctuation.

    4 different assets are traded in futures trading. These are stocks, currency pairs, indices, and commodities. 2 types of traders are there in futures trading; hedgers and speculators.

    Hedgers manage financial risk through futures trading. For example, if there comes a situation when an individual or a company is required to pay a high price for the commodities to a party, he may choose to go for a futures trade. This way, she can cover the cost, manage the risk, and earn profit in the future.

    On the other hand, speculators can be independent floor traders who trade for their own accounts or can be floor brokers monitoring contracts for individuals or brokerage firms.

    In futures trading, time is the main factor that plays a vital role in deciding the profit and loss. The contract has an expiry date, and the price movements between this time would decide the fate of the trader. Also, futures don’t have a definite value as it depends on the price of other derivatives.

    In futures trading, the buyer doesn’t pay the full amount initially. It is just the initial margin that needs to be paid to start the contract. This margin price and maintenance value is determined by exchanges.

    Steps to Futures Trading Online

    Online trading is much more convenient, time-saving, and easier, which makes it a better option than physical trading. So, here are the steps to initiate futures trading online:

    • Firstly, you would have to choose a commodity broker.
    • Secondly, you need to complete the paperwork and open an account. Now, let the broker analyze the market and link you to a suitable trader.
    • Lastly, fund the account after analyzing the trader with the help of your broker.

    Spot Trading vs. Future Trading – Which is Better?

    Which one is better, spot trading or futures trading? This is a crucial question to answer. So, overall it seems like future trading is way better in a lot of ways. Let us see the advantages of futures trading that outweigh the advantages of spot trading.

    Futures are leveraged investments.

    A margin is set by the buyer, who is normally 10% of the total amount. Now depending on the price movement, the buyer has to pay for maintaining the level. The chances are that the price may go up, and the buyer can make a profit. Futures trading opens up the scope of earning a future profit that he couldn’t earn in spot trading.

    The market is liquid.

    The futures market is open and active, making it liquid. Buyers and sellers come up with new contracts frequently, and trading happens quite efficiently. Scopes are broad, and clearing stocks is easier and faster. Also, unlike the spot market, some futures markets stay open even after trading hours.

    Broker cost is low

    As trading is shifting online, broker fees and commissions are becoming less. Some online brokers also offer free services. Even if some brokers are not available for free, the commission percentage is very low, and you need to pay them only after a position is closed. However, the commission and fees depend on the service being provided by the broker.

    Money-making is faster in the futures market.

    Speculators with excellent prevision can make money and profit faster. Usually, the market trend and price movement are predictable if the factors affecting the price can be determined. Now, if the investor invests in a profitable stock, he gets the chance to earn a profit fast.

    It is way better than the spot market as you need to purchase at the spot price and get no time to judge the cost. Whereas in the futures market, you get time to think and consider the price fluctuation that may happen in the future. Also, price movement quite often makes it a profitable deal.

    However, risks are there. This risk can be minimized by the stop-loss order. A Stop-loss order is when the stock is sold as a market order when the price drops below the stop price. The risk factors have to be considered as well when the market moves fast.

    Futures have diversification, and hedging scopes are broad

    Hedging in the futures market helps to manage potential risks. Foreign exchange risk and interest risk are minimized efficiently using futures for companies engaged in foreign trades. They do this by fixing an interest rate predicting that the price would drop only if they are planning to buy a large stock.

    They also reduce the price risk by securing a price for commodities. Derivatives and futures provide the scope of boosting the efficiency of the underlying market as they can reduce the purchase cost outright, suddenly. This means investing in futures would be beneficial and effective usage can broaden the scope.

    The Efficiency and Fairness of the Futures Market are Great

    Information exchange is limited in the futures market. In stocks, insiders and corporate managers may expose confidential information to others which may result in some sort of risk like bankruptcy. But in futures trading, the exchange of information with an insider doesn’t happen. Market aggregates don’t deal with insiders. This makes the whole procedure much more efficient, fluid, and smooth. Also, the investors do fair trading as information leakage doesn’t happen.

    No Trading Occurs; it is only in papers.

    You know that the investment is for the future, and the stocks are bought and sold consecutively. Except for futures commodity trading, there is no actual delivery of stock to the party. It is just a transaction on paper where the buyer seeks an amount of profit in the future.

    Futures trading is much better than keeping a stock share as you need to store it and monitor it continuously. This hassle can be substantially reduced by futures trading.

    Companies keep track of who all owns their shares so that they can pay the dividends and record the votes of the shareholders. In the case of futures trading, you don’t require to keep a record or track of such information.

    Futures Trading Makes Short Selling Easier

    By selling a futures contract, one can legally get a short exposure on a stock. However, short selling is not allowed everywhere, and rules and regulations vary from market to market. You will need a margin account if you want to do short selling.

    In this procedure, you have to borrow shares from a broker that you didn’t have earlier. Only then you can sell this share. A stock that is hard to borrow would be difficult to short sell. Therefore, choose a stock that you can borrow easily from a broker.

    It is to remember that potential risks are there in futures trading too. The risks can be minimized only if the right strategies are maintained and if the investors have the skills to predict and examine the price movement.

    Final Overview

    It can be said that futures trading has more scope than spot trading. The fairness and efficiency are better in futures trading, and it gives the investors enough time to think and decide on where to invest. However, the risk factors should be considered to minimize losses.

    On the other hand, spot trading is somewhat difficult as you need to make decisions on the spot. Also, there remains a fairness issue in spot trading. The scopes are limited, and only experienced traders can make a benefit out of spot trading.

    All in all, looking into the benefits, it can be concluded that futures trading can be more beneficial for traders to earn profit in the long-term and stay risk-free, especially for those who are new to the trading.