Should I Trade Spot or Futures?
Traders often come to the futures market for the cheaper cost of speculation than in the spot market, whether abritarge or directional trading. But futures can also be used for hedging, a feature they were originally developed for.
To understand the differences between these two markets before deciding which one to trade, have a read of our short guide.
What are Futures and Spot?
Contracts such as futures, forwards, and options are derivative products, the prices of which are the underlying market—usually spot. For example, buying a futures contract gives ownership of the underlying asset to the holder of at a future price, which is agreed upon today. Whereas trading on the spot market gives ownership at the prevailing prices.
Futures are financial derivative contracts that inherit their value from different financial assets such as commodities, cryptocurrencies, foreign exchanges, bonds, stock indexes, etc. A futures contract has a fixed price and expiration date, known upfront to the traders. This binds both the sellers and the buyers to execute the deal at this predetermined date and contract price.
Features of a Futures Contract
- Centralized Market: Futures are transacted on exchanges and over-the-counter (OTC) markets, which means that while the trades are done electronically, they are settled in a physical location.
- No Scope for Negotiation: The price and maturity dates of a futures contract are standardized by the exchanges, leaving no scope for negotiation on the buyer and seller.
- Trading of Whole Contracts: A futures contract can be traded only in whole numbers; that is, a trader cannot buy or sell fractional futures contracts. However, this issue is mitigated by the existence of mini and micro futures contracts, allowing for greater flexibility of capitalization. You can read our short guide about that here.
- Mark to Market Mechanism: The profit or loss earned by the holder of a futures contract is calculated continuously and margins are updated daily based on the closing price for the day. In such a case, the traders who have:
- Incurred losses get their margin account debited
- Earned profits get their margin account credited
- No Intention to Take Physical Delivery: The futures contracts are primarily used for hedging, wherein a trader safeguards himself from negative variations in the price of the underlying assets. With a less than 1% delivery rate, most futures contracts are nullified using an opposite marching contract or closed before expiry.
A spot contract is based on the current market price of a financial asset, which is available for immediate settlement. Let’s look at some of the features of spot.
Features of a Spot Market
- Delivery Date: The delivery of the asset under consideration usually takes place immediately with liquid assets.
- Spot Price: All the transactions under a spot contract are made at the current market price, also known as the spot price or spot rate. This price is determined by the market forces of demand and supply.
- Transfer of Funds: The transfer is usually made in cash instantaneously or else is made at T+2.
- Intent to Take Physical Delivery: Unlike futures, traders on the spot market take immediate physical delivery of the underlying asset—in other words: “on the spot”.
Why Trade Spot?
Trading in the spot market is often considered more accessible and less complex than derivatives. It is as simple as buying groceries from a grocery store. Trading in the spot market has several advantages, such as:
- Immediate Delivery: All spot market trades are completed on the spot. This is by far the most significant advantage of a spot market, since traders get immediate delivery (or after 2 working days) of the underlying asset.
- Transparency: Assets in the spot market are transacted at current market prices, which are more transparent and less complex.
- No Minimum Commitment: Unlike futures, there is no requirement for any minimum capital for trading in a spot market. You just have to have the capital at 1-for-1 to make the trade, since there is no leverage available.
Why Trade Futures?
Trading futures is often considered a preferred way when the intent is to hedge or earn profit from speculative trades. It has several advantages, such as:
- High Leverage: Trading in futures is highly capital efficient. A trader is only required to put up a fraction of the total underlying to open a position in the futures market.
- Open Both Long and Short Positions: Unlike the spot market, traders in the futures market can earn profit regardless of price direction.This is made possible by entering into a:
- Long position, if you expect the prices of the underlying asset to move up in the future.
- A short position, if you expect the prices will go down
- Reduced Cost & Slippage: Futures markets are often more liquid than their spot equivalents. This helps the traders to reduce their chances of slippage (the difference between expected price and execution price of a trade) due to high trading volume, often with cheaper commissions than trading assets in the spot market, especially when making many trades.
Both the spot and futures markets are highly vital but very different, each with their own unique features and processes.
Depending upon the requirements, a trader can enter into the spot market (if an actual delivery is required) or a futures market (if the primary purpose is to hedge or speculate).
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