What is the Spot Market?

Traders and investors should be aware of the fundamental nature and functioning of the financial markets. An important part of this journey is understanding what the spot market is. Even though the vast majority of traders and investors participate in this kind of market, they remain unaware of its key features, benefits and limitations. 

In this article, we introduce you to the concept of the spot market and help you understand how to get better at spot trading.

What is the Spot Market?

The spot market is a segment of the financial markets where financial instruments are traded using cash and the delivery is instant. In other words, a trade is completed immediately and not postponed to a future date, as is the case in a futures market. Some examples of securities commonly traded in the spot market include equity shares, currencies, commodities and bonds. 

Trading in the spot market may occur either via exchanges or in over-the-counter (OTC) environments. Although the delivery is immediate, settlement may take one or more days depending on the settlement cycle prevailing in the specific segment that you have traded in. For instance, in the Indian stock market, we have a T+1 settlement cycle, which means that each trade will be settled a on the day after the order is executed. 

What is the Spot Price?

The price at which a financial instrument is traded in the spot market is known as the spot price. This price is not fixed by any external entity. Although the initial price of a stock may be set by the company when it issues the instrument, once the security makes it to the secondary market or the spot market, the prices are subject to change based on the demand and supply forces in action. 

When the demand for an asset rises, its spot price increases. Conversely, when the supply is higher, the spot price falls. For securities that have high liquidity, the spot price may change extremely quickly. So, you need to be mindful of the volatility in spot prices when you trade in the spot market. 

Types of Spot Markets

Depending on how spot trading occurs, the market can be divided into two types. Check out what these two types of spot markets are.

• Exchange-Based Market

In an exchange-based market, trades are executed through a centralised exchange. A common example of this is stock trading in India on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). We also have exchanges for commodity trading like the Multi Commodity Exchange of India (MCX) and the National Commodity & Derivatives Exchange (NCDEX). These exchanges regulate trading by standardising contracts and overseeing the execution of buy and sell orders between traders. 

• Over-the-Counter (OTC) Market

In over-the-counter markets, the trades are carried out directly between the parties involved. There is no exchange or middleman to execute the trades on behalf of the buyers and the sellers. The absence of a centralised exchange means that transactions and contracts in these markets are not standardised. What’s more, the trade may be executed at spot prices or a mutually decided future price. This is at the discretion of the buyer and the seller involved in a trade. 

Key Characteristics of the Spot Market

The spot market is defined by a few key characteristics that set it apart from the derivatives market, where trades occur on a future date. Let us discuss the main features of the spot market. 

• Immediate Settlement

Transactions in the spot market are settled ‘on the spot.’ This means the buyer and the seller exchange assets and make payments immediately or within an ultra-short period. This is quite different from the derivatives market, where contracts are settled on a future date. 

• Delivery of Instruments

Spot trading often involves taking delivery of the instruments traded in the market. These instruments include shares, commodities and currencies. The assets are exchanged directly between the buyer and the seller, unlike in the derivatives market, where contracts are settled in cash. 

• Spot Prices

Trading at the spot market occurs at spot prices. These prices are also hallmarks of trading in the spot segment. The spot price represents the current value of an asset in the market. It is affected by the real-time supply and demand levels. 

• High Liquidity 

The spot market is generally marked by high levels of liquidity. Of course, this may not be true for all the stocks and securities traded on the spot. However, more securities with good fundamental or technical indicators typically witness decent investor or trader activity. 

• Varied Trading Mechanisms

Spot markets can operate through various mechanisms, as mentioned earlier. They include exchanges, over-the-counter (OTC) platforms and direct trades between parties. This flexibility in trading systems makes spot transactions easier and more accessible. 

A Handy Guide to Spot Trading

Spot trading can be highly effective if you know what to do. Here are some pointers that can make trading in the spot market easier for you. 

• Set Clear Goals

Define your spot trading goals before you enter the market. Whether you are aiming for short-term gains or want to make long-term investments, it's important to have clear objectives that will help guide your trades. This will also reduce the risk of impulsive trades.

• Stay Informed

You need to regularly monitor the news and economic events that could impact spot prices. This will allow you to understand the factors that drive supply and demand. You can then anticipate market movements better and make more informed trading decisions. 

• Use Technical Analysis

Technical analysis gives you valuable insights into market behaviour and helps you plan your trades more effectively. Study charts, patterns and technical indicators to identify trends and find potential entry and exit points. 

• Start Small

If you are new to spot trading, begin with small trades to gain more experience. This approach allows you to learn without risking too much capital and helps you build the confidence required to develop your trading strategy. 

• Manage Risk Well

Always use stop-loss orders to limit potential losses in the spot market. Determine the maximum amount you are willing to risk on a trade and stick to it. This disciplined approach will protect your capital and ensure that one bad trade doesn't wipe out your gains.

• Remain Objective and Unbiased

Avoid letting emotions like fear and greed drive your trading decisions. Stick to your trading plan and avoid chasing losses or getting overly excited about potential gains. Emotional trading can lead to poor decisions and unexpected losses. 

• Avoid Panic and Stay Patient

Spot trading can be dynamic and fast-paced, but it's important to wait for the right opportunities. Don't rush into trades without proper analysis, and be patient till the market presents favourable conditions that align with your strategy. 

Advantages of the Spot Market

The spot market can be beneficial to traders and investors alike. Some of the top advantages it offers include the following:

• Transparent Pricing

Prices in this market reflect real-time market conditions. This adds a level of transparency and offers an accurate representation of an asset’s current value. 

• High Liquidity

The spot market typically has high liquidity. This allows you to easily enter or exit positions — which can be particularly useful for short-term trading.

• Quick Settlement

Transactions in this market segment are settled quickly, so you get the benefit of instant ownership or transfer of assets. Such immediacy can be appealing if you want rapid execution. 

• Simplicity

Spot trading is simpler when compared with derivatives trading because it does not involve complex contracts and future settlement dates. This makes the spot market more accessible for beginners too. 

Disadvantages of the Spot Market

The spot market also has some limitations that you need to be aware of. They include the following: 

• Limited Hedging

The spot market offers less protection against future price changes compared to derivatives, making it riskier for traders looking to hedge their positions.

• Market Volatility 

Prices in the spot market can fluctuate rapidly and lead to potential losses if market conditions change unexpectedly.

• Trading Costs

Immediate settlement in the spot market can sometimes lead to higher transaction costs, especially in markets with lower liquidity or larger spreads.

Conclusion

This sums up everything you need to know about what the spot market is and how it works. To trade in this market segment easily, you can open a demat and trading account and carry out trades via the NSE and/or the BSE. Before you place an order, however, you need to back up your trading plan with adequate research. 

Motilal Oswal’s Research 360 platform can help you with this. On this platform, you can perform extensive technical and fundamental analysis for any listed security. This way, whether you are trading over the short term or investing over the long term, you have live market data backing up your decisions.