Understanding Spot Commodities: Key Features and Functions
Spot commodity transactions are very useful when it comes to buying/selling tangible goods. They make delivery as instant as possible. A trader dealing with spot commodities is not liable to any future obligations, which makes it very appealing. You can buy metals, agricultural products, soft products or energy.
Over the past few years, commodity trading industry has witnessed an overwhelming response from traders and investors. Today, the term "spot commodity" is commonly used in the finance and commodities trading ecosystem. But, before you can leap into the world of spot commodities, you must understand what it means and how does it fit into the broader landscape. Read on to know more.
What is a Spot Commodity?
A spot commodity or a spot is a tangible physical commodity that is bought and sold for immediate delivery and settlement i.e. “on the spot”. Simply put, you are buying or selling the actual physical product in a spot commodity transaction and not a contract to buy or sell it in the future.
To better understand this, let’s start with some of the common terminologies used:
Spot price – It is the price paid by the buyer on the spot. It provides potential buyers/sellers clarity on the current market price of an asset. In this case, the asset could be oil, gold, silver, or any other commodity.
Cash settlement – It is the process of using cash instead of physical delivery to settle spot contracts. This means both the parties agree to exchange the difference in the spot price and the contract price in cash.
Bid-ask spread – It is the difference between the bid, which is the highest price a buyer is willing to pay, and the ask, the lowest price a seller is willing to accept. It represents the transaction cost and liquidity of the market.
Market order – Here, a trader agrees to buy or sell a commodity at the current market price. It gets executed immediately at the prevailing spot price.
Limit order - An order placed with specific price instructions. It will only be executed if the market reaches the specified price.
Mark-to-market – It refers to the process of revaluing open spot commodity positions at the current market price to determine gains or losses.
Delivery notice – It is a written notice from the seller to the buyer specifying the details of the delivery, the quantity, quality, and delivery location.
Spot market liquidity – It refers to the ease with which a commodity can be bought or sold in the spot market without significantly impacting its price.
What are the key features of spot commodities?
Immediate Delivery – This is the most defining characteristic of spot commodities. If you purchase a spot commodity, you are expected to take possession of the physical product within a short timeframe, often within a few days or even hours.
No Future Obligations – While futures or forward contracts involve an agreement to buy/sell a commodity at a specified future date and price, spot contracts are free of any future obligations. Once the transaction is complete, both the buyer and seller have fulfilled their responsibilities.
Physical Exchange – Spot commodity transactions often take place on physical exchanges or in physical marketplaces where the deal is finalized after the tangible goods like agricultural products, soft products, or metals are inspected.
Price Determination – Spot commodity prices can be very volatile as they are determined by the forces of supply and demand in the open market. These prices can fluctuate based on factors such as production, weather conditions, geopolitical events, and market sentiment.
Spot commodities differ from futures and forwards contracts, here’s how:
What are key functions of spot in financial markets & economy?
Spot commodities have a vital role to play in:
Price discovery - Spot commodity prices serve as a critical benchmark for the pricing of related futures contracts and financial derivatives. They provide real-time information about the current supply and demand dynamics in the market and are often used by traders to speculate.
Physical supply and demand - Spot markets ensure efficient distribution of physical goods by allowing producers, consumers, and traders to buy and sell commodities as needed. This not only stabilises prices but also guarantees that the goods reach consumers on time.
Risk management – Even though the primary focus is on physical delivery, spot markets also indirectly facilitate risk management. Producers and consumers can make informed decisions about future production, purchasing, and hedging strategies with the help of insights from spot markets.
Spot commodities are the backbone of the commodities trading industry, representing the immediate exchange of physical goods in a transparent marketplace. Understanding spot contracts is essential for anyone involved in the commodities sector, as they serve as the foundation upon which futures, forwards, and other derivative products are built. These markets are dynamic and play a vital role in price discovery, risk management, and the efficient allocation of physical goods in the global economy. As an investor, you must be aware of the inner dynamics and the risks involved so you can protect your investments while trading.