The financial markets have many unique terms that might confuse beginner traders. This article shall cover the main differences between spot, futures, and contracts for differences (CFD) trading.
Depending on where an investor was raised, they could have difficulty understanding some of the terms used in the global financial markets. For example, many beginner Chinese traders may have challenges understanding terms such as ETF, CFD, swap fees and discounts, given that English is not their first language.
However, we cannot dive into the intricacies of trading all the popular types of assets since that would need a whole book. Still, we can focus on the foreign exchange markets and analyse the differences between spot, futures and CFDs, which are the main types of assets that investors will encounter when trading using the popular MT4 platform.
Spot transactions usually have another group of abbreviations that appear with them, such as OTC, which means over-the-counter transactions.
The financial market’s restriction on spot transactions includes the delivery of cash and commodities within two working(trading) days if it is a spot transaction. There are different versions of the XAUUSD gold asset on the MT4 for Mac, PC, iOS, Android applications, which many people think are spot prices, but they are not.
Spot transactions require the buyer to take delivery of physical gold within two working days, while the seller has to deliver physical gold to the buyer. Therefore, most of the gold trades executed by investors and traders alike are not spot transactions.
However, if you decide to take your cash and approach the bank to buy gold bars, the physical gold engraved with “investment gold” is spot gold.
Transactions in the Chinese A-share market are regarded as spot transactions because the equity of a listed company is reflected in your investment account when you buy the firm’s shares, which meets the definition of a spot. Although spot transactions usually result in the physical settlement of actual commodities, they also present the inconvenience of storing the commodity and high processing fees.
Many people who trade commodities are not interested in physical commodities but are solely interested in price fluctuations. Likewise, most traders and investors are interested in speculating on future price movements, not the actual delivery of the asset.
Therefore, we have now exposed the shortcomings of spot transactions, and it is now time to focus on futures, including their advantages and disadvantages.
Futures are different from spot transactions, but they are also related to spot prices. Futures represent the expected prices at a future date, while spot prices are the current market prices. Most people do not understand the mechanism by which futures prices are quoted, which makes them think that futures prices are unpredictable. So, how can futures provide accurate future price quotations? While this is a valid question, traders will see futures prices fluctuating as market conditions reflect current and projected market volatility. Therefore, we cannot judge the different quotes we receive when trading futures, which typically reflect the price changes in the underlying assets.
For example, crude oil futures. The current December contract listed on the MT4 corresponds to the expected crude oil price in December, a few months away. The price of this futures contract is determined by traders and analysts based on a comprehensive analysis of various factors.
Some of the factors considered include the demand and corresponding supply of crude oil globally. As December approaches, we will likely see the crude oil prices being very close to the spot crude oil prices. However, there are no guarantees that the prices will be the same.
The most significant difference between futures and spot transactions is that futures can only be delivered on the expiry date, while spot transactions are delivered within two days. The concept of delivery is quite simple. That is, the physical goods purchased by the trader are shipped to them by the seller. If you close your position before the expiry date, you do not need to take delivery of the assets you were trading. However, you must understand that the delivery process is quite complicated. Unless you are a large institution, ordinary traders and investors generally don’t want to accept deliveries in the futures market because the products delivered are often in large quantities, and the shipping and handling fee is usually extremely high. The traders also need to prepare their warehouses and trucks to stock and transport the delivered commodities.
Many people think that the crude oil trading done on the MT4 platform is based on futures. However, the above misconception is not true since traders cannot take delivery of the crude oil traded on the MT4. Instead, the crude oil traded on the MT4 operates on a “cash delivery” system where traders do not receive actual crude oil on the expiry date but instead receive a cash payment. Traders will receive cash after discounting the market price.
I prefer to call the crude oil assets in the MT4: futures-style CFD contracts. Naturally, the gold trading in MT4 is in the form of spot CFD contracts. The forex traded on the MT4 is also a spot foreign exchange CFD contract.
3. CFD (Contracts for difference)
I can tell you with certainty that all instruments traded on the MT4 platform are CFDs, including the currency pairs, gold and silver, commodities, stock indexes, among others. Spot and physical transactions are closely related, and futures will postpone the time of physical transactions. CFDs simply eliminate the physical transactions completely allowing investors to trade purely based on price quotations.
The history of CFDs is not long, they were originally invented in the London financial markets in the early 1990s with the purpose of further reducing the intermediate costs of transactions, such as stamp duty.
The biggest advantage associated with CFDs is the extremely low transaction costs compared to other tradable instruments. Taking currency pairs as an example, traders do not have to pay any handling fees, as long as they can bear the difference (spread) between the buying price and the selling price.
CFD trading represents a quotation of the corresponding investment product. Whether the underlying investment product is from spot or futures markets, there is no physical delivery of any products. However, if the delivery date of a futures contract arrives, it will be discounted and delivered in cash.
Since the CFD market does not have the same restrictions as the spot and futures markets, traders tend to use more leverage with many brokers offering leverage of up to 1:200 on certain instruments.
The spot and futures markets have a long history and are widely accepted and understood by most investors. However, most people are unaware of their related operating mechanisms. CFDs are quite different from spot and futures contracts as they offer greater flexibility to investors. Some people have criticised CFD trading because of its short history and the lack of the delivery of physical commodities.
In my opinion, the characteristics of CFDs imply that it is not suitable for large institutions that value physical guarantees and would like to take delivery of the commodities traded. However, for most retail traders, the physical delivery is not important. To the contrary, it is very necessary to trade small sizes and use high leverage to maximise their gains. Only the CFDs The market can satisfy the needs of retail traders who do not have the massive funds that institutions have.
Everyone has different needs. The financial markets do not necessarily teach investors what to do, but they provide enough products and options to suit the different needs of each trader. Therefore, the CFD market is legitimate and it exists to serve the specific needs of retail traders.