What is the spot market & how does it work?

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The spot market of a commodity is a market where buyers meet sellers and make an immediate exchange. In other words, delivery takes place at the same time payment is made.

This is the simplest spot market definition available.

Commodity markets are somewhat different from the markets for stocks, bonds, mutual funds, and ETFs, all of which trade exclusively through brokerages. Because they represent a physical good, commodities have an additional market—the spot market. This market represents a place where the actual commodity gets bought and sold right away.

One example of a spot market is a coin shop where an individual investor goes to buy gold or silver coin. The prices would be determined by supply and demand. The goods would be delivered upon receipt of payment.

Futures markets, by contrast, operate on a longer time horizon. Traders buy and sell futures contracts according to what they believe the price of an asset will trade at in the future.

Futures contracts began in the farming industry. Farmers needed a way to hedge their income against the unpredictability of crop yields arising from irregular weather patterns. Using futures allowed them to lock in a certain amount of income ahead of time.

Even today, people who produce goods often sell futures contracts so they can guarantee a certain market price for their products in the future. And those who purchase goods buy futures contracts so they can predict how much they will need to spend on certain commodities.

Related: Investing in precious metals

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What Does the Spot Price Mean?

What is the spot market & how does it work?

The spot price simply refers to the price at which a commodity can be bought or sold in real-time, or “on the spot.” This is the price an individual investor will pay for something if they want it right now without having to wait until some future date.

Because of this dynamic, spot markets are thought to reflect genuine supply and demand to a high degree.

The interplay of real supply and demand leads to constantly fluctuating spot prices. When supply tightens or demand rises, prices tend to go up, and when supply increases or demand falls, prices tend to go down.

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The Significance of a Spot Market

What is the spot market & how does it work?

The spot market of any asset holds special significance in terms of price discovery. It’s thought to be a more honest assessment of economic reality.

The reason is that spot markets tend to be more reliant on real buyers and sellers, and therefore should more accurately reflect current supply and demand than futures markets (which are based on speculation and can be manipulated, as recent legal cases have shown. More on this later.).

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Types of Spot Markets

What is the spot market & how does it work?

There’s only one type of spot market—the type where delivery of an asset takes place right away.

There are two ways this can happen, however. The delivery can take place through a centralized exchange, or the trade can happen over the counter. OTC trades are negotiated between two parties, like the example of buying coins at a coin shop.

But there are different spot markets for different commodities, and some of them work slightly differently than others.

The spot market for oil, for example, also has buyers and sellers, but a barrel of oil can’t be bought at a local shop. The same goes for some industrial metals like steel and aluminum, which are bought and sold in much higher quantities than silver and gold.

Agricultural commodities like soy, wheat, and corn also have spot markets as well as futures markets.

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Spot Market vs. Futures Market

What is the spot market & how does it work?

One instance that makes clear the difference between a spot market and a futures market is the price of precious metals.

Gold, silver, platinum, and palladium all have their own spot markets and futures markets. When investors check the price of gold on a mainstream financial news network, they are likely going to see the COMEX futures price.

COMEX is short for Commodity Exchange Inc., a division of the New York Mercantile Exchange. As the largest metals futures market in the world, COMEX handles most related futures contracts.

These contracts are speculatory in nature — traders are making bets on what the price of a commodity will be at some point. Contracts can be bought and sold for specific prices on specific dates.

Most of the contracts are never delivered upon, meaning they don’t involve the delivery of the actual underlying commodity, such as gold or silver. Instead, what gets exchanged is a contract or agreement allowing for the potential delivery of a certain amount of metal for a certain price on a certain date.

For the most part, futures trading only has two purposes: hedging bets and speculating for profits. Sophisticated traders sometimes use futures to hedge their bets, meaning they purchase futures that will wind up minimizing their losses in another bet if it doesn’t go their way.

And investors of all experience levels can use futures to try to profit from the future price action of an asset. Predicting the exact price of something in the future can be difficult and carries high risk.

The spot market works in a different manner entirely. There are no contracts to buy or sell and no future prices to consider. The market is simply determined by what one party is willing to purchase something for.

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Example of a Spot Market

What is the spot market & how does it work?

Consider the spot and futures markets for precious metals.

Precious-metal prices that investors see on financial news networks will most often be the current futures price as determined by COMEX. This market price is easy to quote. It’s the sum of all futures trading happening on one central exchange or just a few central exchanges.

The spot market is more difficult to pin down. In this case, the spot market could be generally referred to as the average price that a person would be willing to pay for a single ounce of gold or silver, not including any premiums charged by sellers.

Sometimes there is a difference between prices in the futures market and spot market. The difference is referred to as the “spread.” Under ordinary circumstances, the difference will be modest. During times of uncertainty, though, the spread can become extreme.

During the panic of February and March 2020, when governments began imposing restrictions on travel and businesses in response to the coronavirus pandemic, the spread between gold and silver futures and spot markets began widening dramatically. This was exacerbated by the fact that premiums (the amount that coin dealers charge buyers on top of the spot price) were also rising.

When silver was at its lowest, trading around $12 per ounce on the COMEX, the spot market for silver was either sold out or going for $24 per ounce, twice the price of the futures market!

During that time, there were also many futures contracts for which customers requested physical delivery. That means some of the people who held the contracts chose to exercise the option to take ownership of the physical metal.

In a spot market, no such agreements exist, because the physical exchange is the market itself. Using this example, a buyer provides cash and a seller provides gold (or silver or another precious metal).

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Futures Market Manipulation

What is the spot market & how does it work?

To fully answer the question “What does the spot price mean?” it’s important to include one final note on futures markets. This will illustrate a key difference between the two markets.

Recent high-profile cases brought by government enforcement agencies like the Securities and Exchange Commission and Commodities and Futures Trading Commission highlight the susceptibility of futures markets to manipulation.

Some large financial institutions have been convicted of engaging in practices that artificially influence the price of futures contracts. Again, we can turn to the precious-metals markets for an example.

During the third quarter of 2020, JP Morgan was fined $920 million for “spoofing” trades in the gold and silver futures markets and lying about it to COMEX.

Spoofing involves creating large numbers of buy or sell orders with no intention of fulfilling the orders.

Because order book information is publicly available, traders can see these orders and may act on the perception that big buying or selling pressure is coming down the pike.

If many sell orders are on the books, traders may sell, hoping to get ahead of the trade before prices fall. If many buy orders are on the books, traders may buy, thinking the price is going to rise soon.

Cases like this show that futures markets can be heavily influenced by market participants with the means to do so.

Spot markets, on the other hand, are much more organic and more difficult to manipulate.

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This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

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