Understanding the Difference Between Spot, Futures, and Forwards Markets

Understanding the Difference Between Spot, Futures, and Forwards Markets

  • Posted on 0202-0707-2020
  • by Gareth McCauley

Foreign exchange or forex trading has been gaining momentum, especially these past few years. Despite being a relative newcomer in the world of capital markets (particularly compared to the stock market), forex trading is now the largest and most liquid asset market in the world according to Investopedia, trading around $5.1 trillion every day, around the world.

It has also been made more accessible to individuals and organizations alike by the huge strides taken by information and communication technologies. It’s gotten so huge and accessible that this Forbes article is recommending foreign exchange as an additional stream of income for anyone, even without prior experience or knowledge.

And that’s just all right for the most part. After all, we at Fair Forex are here to answer all your questions and help you build your wealth.

If you’re fairly new to the world of foreign exchange trading, you’ve likely encountered the terms spot, forwards, and futures markets referring to different ways forex is traded. This post will explain each one and detail some advantages and disadvantages in relation to one another.

 

Spot Market Trading

This is currently the most popular way of exchanging currencies between institutions, corporations, and individuals. In fact, the forwards and futures markets are, in large part, based on the spot market.

The popularity of the spot market has been further enhanced by the innovations in ICTs that eventually allowed widespread electronic trading and the subsequent rise in numbers of forex brokers. These new platforms opened the doors for more people to essentially get into foreign exchange trading.

Today, most people refer to the spot market when they talk about forex trading.

Basically, in the spot market, currencies are sold and bought according to the current market price. This price is affected by an array of factors including supply and demand, current interest rates, economic performance, sentiment surrounding the current domestic and international political landscapes, speculation towards the given currency compared to others, and many more.

A deal is made in the spot market after two parties agree upon a value and they conduct a bilateral transaction where they exchange different currencies in cash at the settlement. Although the market is widely regarded as having its transactions in the present, these spot deals usually take two days to be settled.

Notable advantages of trading in the spot market include:

  • In an interview with Money Show, Boris Schlossberg, the Managing Director of FX Strategy at BK Asset Management, said the flexibility that the spot market offers allows people more access compared to the futures market. Spot deals can come in anywhere from small to big trades. Participating in the futures market usually entails bigger trades with bigger amounts.
  • Schlossberg added that greater activity in the market – with the participation of other institutions like hedge funds, High-frequency trading or HFTs, and others – is creating better pricing especially for retail traders.

 

Futures and Forwards Market

These markets don’t actually trade in currencies like the spot market. They deal in contracts that specify the price and a future date. These contracts also represent claims to particular currency types. Basically, those deal with futures and forwards contracts enter into an agreement that has delivery and settlement dates in the future. Upon expiration of the contracts, cash is usually exchanged.

The main difference between futures and forwards contracts is that trading with the former is standardized because all trades go through a centralized market, while trading forwards contracts is done OTC or over the counter, between two parties. This means the details in a futures contract are standard across all trades and cannot be customized. The details of a forwards contract on the other hand are based on what the two parties end up agreeing on, making it more customizable.

Here are some of the strengths these contracts offer:

  • Unlike the spot market, these contracts can be used to protect investors from exchange rate fluctuations that can cause financial losses.
  • The standardization offered in futures contracts makes it easier for parties to access them.
  • Futures contracts are transferable which means they can be sold to other parties before their expiration dates.
  • There is virtually no risk of counterparty default with futures contracts because they are marked to market. This means parties need to have enough money in their accounts at all times to match the value of the contract. Parties in these contracts also usually need to post collateral.

Understanding the differences between spot, futures, and forwards markets will help you see your options when forex trading. If you want to learn more about them or about other similar topics, feel free to give us a call or send us an email. Here’s our contact page for your reference.