5 Key Differences between the Spot Market and Futures Market
The spot markets and the futures markets are closely interlinked and for the futures trader it is essential to understand how the spot markets operate as it has an influence on the futures markets.
Many traders often ask the question as to which of these two markets are better to trade. Indeed, for example you can trade Gold (XAUUSD) in the spot markets, and you could also trade the Comex Gold futures. So for an instrument that is pretty much the same but the difference being the type of market that it is traded at, the question is of course logical. Does one market offer better access to pricing or are there certain benefits that put one type of markets at an advantage over the other?
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In this article, we look and five key differences between the spot and the futures markets. However, before we get into the differences, it is best to first understand what the spot markets and the futures markets are.
What is a spot market?
The term spot market is also referred to as cash market, depending on the context. A spot market represents a marketplace for the immediate settlement for the financial instruments that are transacted. The financial instruments can be commodities or any other securities for that matter. Based on above definition, a spot market is therefore referred to the over-the-counter markets in the context of currency trading, or it could also be the NYSE where stocks are traded and is referred to as the cash markets.
The cash markets or the spot markets, as the name suggests is a marketplace where trades are settled immediately. This means that the prices that you see in the spot markets are the current prices for the particular day/time and accurately reflects the buying or the selling prices of the assets that speculators are willing to transact.
What is a futures market?
A futures market is a market where market participants buy and sell contracts in financial instruments for delivery on a specified date in the future. The futures markets include various instruments such as commodities, stock indexes, and currencies and even select stocks. However, the pricing in the futures markets tracks the prices of the underlying asset in the cash or spot market.
The futures markets are known as derivatives markets for a reason because the futures instruments pricing is based on and dependent on the price from the spot or cash markets.
The table below shows an example of some spot and futures market prices.
Starting from the top, the first instrument you see is the Euro Fx futures (E6H2017) which is followed by the EURUSD spot forex market pricing. This is followed by Gold futures and spot gold (XAUUSD) and the ES (emini futures) and the S&P500 stock index. As you can see there are some subtle differences in the pricing which you will find out why in the remainder of this article.
1. Futures trades are settled on an exchange
Spot markets are typically traded over-the-counter
Starting with the most obvious difference, futures trades are settled on an exchange such as the Chicago Mercantile Group (CME) or the ICE futures exchange. The benefit of trading with an exchange settled financial product is that there is trade transparency and counterparty security. For example, if you were trading a futures contract, you would be required to put up an initial margin known as a performance bond. For futures traders who hold trades overnight, a maintenance margin is required. These margins are put in place to avoid counter-party risk. When price has moved significantly in your favor, then the futures prices are marked-to-market, which means that the profit is credited to your account from the maintenance margin.
Similarly if a trade moves significantly opposite to your order the difference is made up by the amount being deducted from your maintenance margin. When the maintenance margin falls below the initial margin, you are issued a margin call and you are required to immediately fund your account to avoid liquidation. These procedures are put in place in order to ensure that the counter party risks are minimized.
When you trade a spot market product such as spot gold or spot currencies, the only margin that you put up is collateral for using leverage. The margin in the spot markets is merely used as an upfront fee with the broker and has nothing to do with counter-party risk.
According to research conducted by the IMF, data showed that counter party risks emanated for a number of reasons such as re-pricing, gap risk or simply a counterparty fail. The IMF's research paper showed that counterparty risk largely comes from the creditworthiness of the institution and in the context of the OTC markets the institutions are comprised of banks, broker dealers and non-banking institutions.
Besides the counterparty risk, the futures trades are publicly available from the exchange in the daily settlement which is published on a daily basis at the end of the trading day.
2. Spot market price settlement occurs within 2 working days
Futures markets have a settlement at the future date
When you trade the spot markets, the settlement is done within two working days. While this might dilute the term "spot" the two working day term was put in place as it typically takes two working days for cash to be transferred from the buyer to the seller. However, in most cases, spot market prices are settled nearly in real time especially with spot forex markets where transactions that are conducted electronically are settled immediately.
In the futures markets, as the structure determines the underlying asset is delivered at the specified settlement date of the futures contract. Unlike the spot market financial instrument, in the futures market you are required to rollover the contract before the expiry date of the contract, failing which the holder of the futures contract ends up either taking or obliged to deliver the underlying asset.
In other words, you would go to the spot market if you wanted to buy or sell something today. On the other hand, you would go to the futures market if you want to buy or sell something at a future date but you want to fix the price today.
The above difference between the spot and futures markets is important as it affects the trader behavior and partly explains the speculative nature of the futures markets.
For example, if you had a long exposure to a certain commodity in the spot markets, then you can hedge the short term corrections in the commodity by hedging in the futures market by shorting the futures equivalent of the underlying commodity or instrument. A majority of market participants in the futures market (depending on the type of asset being traded) is made up of producers and hedgers who have similar direct exposure to the underlying market. Thus, the futures equivalent contracts are used as hedging tools to protect against the risks.
3. Futures are best for trading commodities
Similar to stocks being the best for trading equities
Although the futures markets today are made up of interest rates derivatives, Treasuries, stock index futures among other things, the futures markets were primarily known for trading commodities such as agriculture, meats, softs and other similar commodities.
In the U.S. grains were one of the first commodities to be traded in the early 1800's and began trading as a forward contract. In 19848, the Chicago Board of Trade (CBOT) was formed as an exchange where farmers and merchants could get together to negotiate prices and buy/sell commodities for cash. The buying and selling process was eventually streamlined into standardized contracts.
For nearly 100 years, agricultural products were the most commonly traded products in futures which slowly began to expand to include other commodities such as Soybeans in 1936, cotton futures in 1940 and so on. Precious metals started to trade in the futures exchange since 1960's and currency futures began to appear in the 70's after the Bretton Woods agreement where the U.S. dollar was de-pegged from gold.
When it comes to trading commodities the futures derivatives offer a better alternative than the equivalent cash market. For example, lean hog cash markets typically vary based on the geographic location making it impossible for a remote trade or a speculator to trade the physical cash markets. Thus, the futures markets make it relatively easy as the pricing is uniform and standardized.
4. Futures prices are different from spot market prices
Futures prices are different because of cost of carry and interest rates
Although futures prices are settled on a daily basis, marked-to-market, the price of the futures contracts differ from the underlying spot or cash market equivalent prices. The futures prices rise and fall in tandem with the spot market equivalent known as the mark to market which is done on a daily basis to reduce credit risk by the exchange.
When trading futures, traders need to take into account some additional costs, which eventually lead to the difference in the pricing between the futures and spot market prices.
Cost of carry is a cost that is incurred by the investor or speculator as a result of maintaining or holding a position in the market. The cost of carry can come in different ways including interest costs on bonds, cost of storage for commodities. In the futures markets, cost of carry includes the cost of various expenses that are incurred during the period of the contract that you trade.
Despite the differences in price of the futures and the spot markets, towards the contract’s expiry date, the futures price and the spot price tend to converge.
5. Futures contracts are leveraged
Unlike spot or cash market contracts
One of the major distinctions between futures and spot markets is the fact that futures contracts are leveraged. While some spot markets such as the forex OTC markets can be leveraged, the way margin and leverage works in both these markets are very different.
In futures, every contract controls a specified amount of units of the underlying commodity or asset. For example a standard corn futures contract controls 5000 bushels of corn. Thus, if corn was trading at $7 a bushel, then one futures contract has a value of $35,000. Another example of leverage is crude oil. A standard crude oil futures contract controls 1000 barrels of oil. If the price of oil was $50 a barrel, then a standard futures contract would have a value of $50,000.
When you trade futures, you are required to post an initial margin or a performance bond. This is the amount of money you must commit in order to contract one standard contract. Say for example if you were to day trade crude oil futures contracts for which the margin requirement is $1000. To understand the level of leverage you are using, simply calculate the value of one futures contract by the deposit margin. In this case, it would come to 50000/1000 = 50, or in other words, crude oil futures contracts have a leverage of 1:50 when you are day trading. Of course for swing trading, the margin requirements are much higher. An initial margin of $3250 is required to trade crude oil, which translates to a margin of 1:15 approximately.
In the spot markets which is made up of either OTC or the cash markets which could be the stock exchange, the leverage depends on the instrument and the broker that you are trading through. Most retail OTC forex brokers are required to offer leverage no more than 1:50, while non-U.S. domiciled forex brokers offer higher leverage of 1:200 or more. Needless to say, the risk factor increases tremendously when you opt for higher leverage.
To conclude, the cash or OTC market has its own pros and cons compared to the futures markets. The futures markets are traded for different reasons but largely used as hedging tool against exposure to the underlying market. The fact that futures contracts are leveraged is also another factor why traders flock to trading the futures markets which are centralized and licensed in the U.S.