What Are Futures and How Do They Differ From the Spot Market? Thursday October 17th, 2024 – Posted in: Arbitrage Software, Forex trading

Futures and the spot market are two key financial instruments actively used by both individual traders and institutional investors. However, despite their popularity, many beginner traders do not fully understand the differences between these instruments and their unique features. In this article, we will look at what futures are, the differences between the futures and spot markets, the features of arbitrage on these markets, and pair trading between spot and futures indices and metals.

What Are Futures?

Futures are derivative financial instruments that represent an agreement between two parties to buy or sell an underlying asset (such as oil, gold, stocks) at a future date for a predetermined price. This allows traders to lock in the price of an asset in advance, avoiding market fluctuations.

Futures contracts are traded on organized exchanges like the CME (Chicago Mercantile Exchange), where contract terms, including volumes and delivery dates, are standardized. Examples of futures include contracts on oil, agricultural products, currencies, stock indices, and much more.

Features of Futures:

Obligation to Execute: When buying or selling a futures contract, both parties commit to execute the deal in the future. The buyer must purchase the asset, and the seller must sell it.
Standardization: Futures contracts are standardized, meaning their volumes, delivery dates, and terms of execution are predefined.
Margin Requirements: Futures allow for leverage, meaning traders can open positions for amounts greater than their current capital. They must provide a deposit known as margin.
Risk Hedging: Futures are widely used for hedging—protecting against unfavorable price changes. For example, a farmer can sell futures on their product to protect against price drops.

What Is the Spot Market?

The spot market (or cash market) is where transactions are made for immediate delivery of the asset. Unlike the futures market, where deals are made with future execution, the spot market’s buying and selling occur almost instantly. The asset’s price on the spot market is known as the spot price.

Features of the Spot Market:

Immediate Delivery: Assets in the spot market are bought and sold for immediate delivery. This can be either physical delivery (such as metals or oil) or monetary settlements (as on currency markets).
Simplicity and Transparency: The spot market is straightforward and transparent, as deals are executed at the current market price, reflecting immediate demand and supply.
No Future Obligations: Unlike futures, the spot market does not have obligations regarding future performance. Transactions are completed upon execution.
High Liquidity: Most assets on the spot market are highly liquid, as they are in demand for immediate use.

Key Differences Between the Futures Market and the Spot Market

Although futures and spot markets may trade the same assets, they differ significantly in many aspects. Here are the key differences:

Criteria	Futures Market	Spot Market
Execution Time	Deal is executed in the future at a predetermined price	Deal is executed immediately after being made
Obligations	Buyer and seller are obligated to execute the contract in the future	No future obligations
Use of Margin	Margin deposits are required to open positions	Transactions occur for the full value of the asset
Hedging	Commonly used for risk hedging	Rarely used for hedging
Types of Assets	Standardized contracts for commodities, currencies, indices	Physical assets, currencies, raw materials
Leverage	Often used to increase trading volumes	Usually absent or rarely used
Volatility	Futures prices can deviate from spot prices due to expectations	Spot prices reflect current supply and demand

Arbitrage on the Spot and Futures Markets

Arbitrage is a trading strategy where traders profit from the price difference of the same asset across different markets. Arbitrage is possible on both the spot and futures markets, but these markets offer different opportunities and risks.

Arbitrage on the Spot Market

Arbitrage on the spot market involves buying and selling an asset on different platforms or exchanges where prices may differ. The main goal of an arbitrageur is to quickly capitalize on price discrepancies.

Features of Arbitrage on the Spot Market:

Instant Execution: Since spot market deals are executed immediately, arbitrageurs must act quickly to take advantage of price differences.
Different Exchanges: Arbitrage can occur between exchanges with varying liquidity and demand conditions. For example, currencies or cryptocurrencies may be priced differently across exchanges.
Transaction Costs: Commissions for trades and transfers between exchanges can eat into profits, so they must be considered when arbitraging.

Arbitrage on the Futures Market

Arbitrage on the futures market involves profiting from the difference between the price of an asset on the spot market and its futures price. Traders can buy the asset on the spot market and sell a futures contract on it, locking in the price difference as profit.

Features of Arbitrage on the Futures Market:

Hedging Risks: Traders can hedge their positions by buying on one market and selling on another, reducing the risk of losses due to unfavorable price changes.
Margin Requirements: Futures contracts require margin, allowing traders to use leverage and open larger positions.
Difference in Execution Time: Arbitrage with futures requires considering that futures contracts are executed in the future, so the price difference may change over time.

Comparison of Arbitrage on the Spot and Futures Markets

Criteria	Arbitrage on the Spot Market	Arbitrage on the Futures Market
Type of Deal	Buying and selling an asset on spot markets	Buying on the spot market and selling a futures contract
Use of Margin	Rarely used	Commonly used thanks to margin requirements
Risks	Price volatility on the spot market	Price difference between spot and futures markets
Execution Time	Immediate execution of deals	Contract executed in the future
Transaction Costs	Commissions for trades and transfers between exchanges	Commissions for futures and margin requirements

Pair Trading Between Spot and Futures Indices and Metals

Pair trading is a market-neutral strategy that involves taking two opposing positions on correlated assets to profit from their price divergence. On spot and futures markets, this strategy is often applied to assets like indices and metals, taking advantage of the price differences between their spot and futures prices.

Pair Trading Between Spot and Futures Indices

Traders often engage in pair trading between spot indices (such as the S&P 500 or NASDAQ) and their corresponding futures contracts. By taking a long position in one and a short position in the other, they aim to profit from the narrowing or widening of the price spread between the spot index and the futures price.

Features of Pair Trading with Indices:

Hedging: This strategy helps to hedge risk since one asset acts as a hedge against the other.
Leverage: Futures contracts allow for the use of leverage, which can amplify profits or losses.
Market Sentiment: Futures often reflect market expectations for the future, while spot prices reflect the current situation. Pair trading aims to profit from the correction of these differences.

Pair Trading Between Spot and Futures Metals

Similar opportunities exist for metals such as gold (XAUUSD) or silver (XAGUSD), where traders can simultaneously trade the spot price and the futures contract. By buying the metal on the spot market and selling the futures contract (or vice versa), traders profit from the price discrepancies that occur due to differences in market expectations and current demand.

Features of Pair Trading with Metals:

Seasonality and Economic Events: Metals are often influenced by macroeconomic factors, geopolitical events, and supply-demand dynamics. These can create opportunities for arbitrage between the spot and futures markets.
Storage Costs and Interest Rates: In futures markets, storage costs and interest rates can influence the price difference between spot and futures contracts. Pair traders often take these factors into account.

Advantages of Pair Trading with Spot and Futures Markets:

Lower Market Risk: Since pair trading is a market-neutral strategy, it reduces the overall exposure to market movements.
Leverage on Futures: The use of margin in futures trading allows traders to enter larger positions with less capital.
Hedging and Arbitrage: Pair trading naturally incorporates hedging and arbitrage opportunities, where traders can balance risk and take advantage of mispricing.

Conclusion

The futures and spot markets offer traders various opportunities to work with assets, and arbitrage on each of these markets has its own features. Arbitrage on the spot market requires quick reactions to price discrepancies and involves transaction costs. Arbitrage on the futures market involves predicting future prices and using margin positions to increase profits. Pair trading, which combines positions on the spot and futures markets, provides unique advantages for traders seeking to profit from price divergence while mitigating risk.

Whether through arbitrage or pair trading, futures and spot markets can yield significant profits if approached with a sound assessment of risks and opportunities. Understanding these markets, their differences, and how to apply strategies like pair trading can help traders unlock more potential in their trading activities.