Investing terminology can get confusing, and foreign exchange transactions don’t make things any easier. You may often hear the terms “spot” and “future” thrown around effortlessly if you watch investment news shows or read articles on the internet, and understanding what the terms really mean will make your life a whole lot easier.
When you think of the word “spot”, think of “on the spot” or immediate. The spot rate of a commodity, currency or security is the quote given for a transaction’s immediate settlement, with the settlement date usually taking place a couple of days after a trade is executed. It’s like saying, “I want to buy U.S. dollars right now”. The spot rate is locked in when the transaction is agreed to. The spot market is a 24-hour a day market, and transactions can be made at a bank, by phone or by the internet.
Futures rates and contracts are a little different. A futures contract between two parties sets the price now, but the whole transaction doesn’t have to be settled immediately. The two parties can agree to settle at a future date more than a day or two down the line. When the agreed upon time is reached the transaction will be paid for and the commodity, currency or security delivered. Quite often the futures rate is locked in, but delivery occurs three months later. Futures are also traded on central futures exchanges, such as the Chicago Mercantile Exchange (CME). Unlike the market for spot rates, futures usually are traded in set hours, like stocks in the stock market. Although, all night markets do exist in futures, they are largely illiquid, rarely traded and are inaccessible to average traders.
The main difference between spots and futures is the actual delivery of currency. In futures, the price is settled when the contract is signed and the currencies are exchanged. In the spot forex, the price is determined at the point of trade, and the physical exchange of the currencies takes place at that moment or within a short period of time. Although, many futures traders tend to close out their positions before the contract expires.
In addition, spot trading provides increased liquidity and lower trading costs than futures trading. Unlike futures, spot trades do not include exchange fees and NFA (National Futures Asscociation) commissions, which are usually passed on to the traders.