What is a Spot Transaction, and How Does It Work?
If you’ve just signed up for foreign exchange purchases and sales, you might have come across a new term: spot transactions. It is one of the many financial transaction methods in the foreign exchange market, but it is not complicated.
A spot transaction is the purchase or sale of a foreign currency or financial instrument that requires instant delivery on a specified date. The delivery date is the spot date, and the transaction's exchange rate is the spot exchange rate.
Understanding How a Spot Transaction Works
Traders in spot transactions physically deliver the currency, instrument, or commodity to the buyer. The seller specifies the rates and the bills they want to be paid, and the payments happen immediately.
In foreign exchange, the buyer identifies a currency they wish to buy. Buyers consider bills that they anticipate to rise in value within a short time, to make a profit upon selling them.
The seller chooses to be paid in a certain currency of the exact amount to avoid delayed payment methods. The seller could also state the time they want the buyer to pay, which could be immediately after the purchase or a few hours after.
However, some transactions like e-transfers could delay up to two business days due to delays in transferring funds between bank accounts. Spot transactions can get done over the counter or on an exchange.
Besides foreign exchange, there are other payments identified as spot transactions. For example, purchasing goods and services requires the buyer to pay the price immediately, making it a spot transaction.
Spot foreign exchange market trades are electronic so that they can happen globally. As a result, the price of the financial instrument is called the spot price, and the buyers and sellers create it.
Note that the spot prices are not constant. They keep changing since orders are constantly purchased, and new ones get to the market. The foreign exchange market is the largest in the world.
Types of Assets Traded On Spot Markets
A spot market is not limited to foreign exchange traders only. Other traders in this market are sellers and buyers of fixed-income income instruments like bonds and treasury bills.
You can also trade tangible commodities like metals, agricultural produce, and livestock or sell perishable and non-perishable items. Crude oil is the most traded commodity in this market.
Types of Spot Markets
There are two significant types of spot markets; over-the-counter and market exchanges.
The over-the-counter spot market allows traders to exchange commodities without a third party or a currency exchange institution. Instead, traders exchange items on the spot and can discuss and negotiate the terms of trade.
There is less standardization of the traded items in spot markets. For example, goods are of different prices, quantities, and types. In addition, traders in this market are private, so their prices are not published anywhere.
Unlike in the over-the-counter spot markets, buyers and sellers state their prices in market exchanges. This type of spot market enables buyers and sellers to meet to bid and offer available commodities.
Currency exchange can be done electronically in market exchanges, making trading more efficient. Many trades take place in this market, and prices are determined instantly.
Sellers and buyers can deal in various financial instruments, but some narrow down to a niche. There are brokers in the spot market. The exchanges are standardized, unlike in the over-the-counter spot market.
The buyers and sellers set spot prices in market exchanges, which can change anytime. There are minimum prices for assets and minimum set quantities and values.
Benefits of Spot Transaction to Seller and Buyer
Many sellers prefer spot transactions due to their benefits. The seller can access the funds immediately after a successful sale, making it possible for them to continue investing in other projects.
Other transactions, like cheques and bank transfers, might take a while. This causes a delay for the seller, who cannot move forward without being paid for the sold items.
A spot transaction is also beneficial to the buyer. Paying for the acquisitions enables them to sell them for another currency. If they paid for the assets days after purchase, reselling would not be possible because they don't fully own the acquired items.
However, the spot transaction is a disadvantage to some buyers. You cannot participate in buying assets if you don't have ready cash. This means that if you don't have money on the day of the trade, you won't be able to buy your desired assets.
How to Manage Risk in Spot Markets
Once you know 'what is a spot transaction,' the next step is knowing how to manage risks. Unfortunately, most traders do not take time to understand how the market works and fail to strategize their trading, incurring losses.
Some sure ways to avoid risks in this market are:
Understand how the market works
It is easy to hop onto the trend of spot transactions without understanding the market first. That happens to traders who are thirsty to make profits but incur losses. However, once you know the market, you can trade with caution.
Traders should prepare before spot trading by understanding the demand and supply function, trading terms, pricing, and nature of the market participants.
If you participate in the over-the-counter spot market, ensure you evaluate the counterparty to reduce default risks.
As a trader on the spot markets, having a trading strategy enables you to detect risks and avoid them before you incur losses. For example, determine your entry and exit points on certain assets before opening the position.
You should also be able to detect a risk on a counterparty to avoid losses. Other trading strategies that ensure your safety in the spot market are price limits and price floors to decide whether it is worth continuing with a specific trade.
Ensure you have a limit order, where you don't allow prices lower than your chosen level. You should also have a regular stop where positions are automatically closed if there is an automatic movement in the market that does not favor your terms.
Information is an important weapon to have in the spot market. Being updated with the current news enables you to know the issues around specific assets and commodities, and you can adjust your strategies accordingly.
It would help if you were keen on economic and financial news. Political changes also disrupt the market and could affect prices. Watching news channels and reading newspapers are ways to ensure you are updated.
Any slight changes in the spot market can change the participants' emotions. For example, price changes or political instabilities cause traders fear, doubt, and anxiety, causing some to make rushed decisions.
Being able to manage emotions keeps you in the right state of mind to make judgments. Conversely, compromising decision-making can cause huge losses to a trader.
Spot transactions are common in selling and purchasing foreign currency, financial instruments, and other fixed-income instruments like bonds and treasury bills. The buyers and sellers in the spot market determine the spot price. The two main types of spot markets are over-the-counter and organized market exchange.