Spot trading is a popular trading method — but how is it different from futures and options trading? And what risks do you need to consider before investing in spot markets?
Spot trading is one of the most basic ways to trade or invest in crypto. Many new investors and traders start their crypto journey by interacting with the spot market.
In this article, CMC Academy dives into what spot trading is, how to trade spot markets, and its risks and benefits.
What Is Spot Trading in Crypto?
Spot trading is a simple concept in which traders buy crypto assets and wait for them to rise in value. For example, when trader Sue buys a position in Bitcoin, she hopes that she will be able to sell it for profit at a later stage.
In spot trading, you buy the asset with your own money. This means you can only buy as much as you can afford, and nothing more. For this reason, it is considered relatively safer than other trading markets. In the worst-case scenario, you lose all the money you invested. Other trading methods, such as margin trading, can cost you even more. In this market, even when the token becomes worthless, you will never be forced to sell.
How Do You Profit From Spot Trading?
Generally, spot traders buy assets, like cryptocurrency or stocks, at a low price and wait for their value to increase before selling them. Because of the nature of spot trading, this method of investing allows you to hold your tokens for multiple years.
Many traders use spot markets to dollar-cost-average into their favorite cryptocurrencies and wait for the next bull market to realize their profits. Since most crypto coins eventually go up, patient traders generally make good profits.
It is important to remember that the profits only become real after you sell your crypto for fiat currency or your stablecoin of choice.
In traditional markets, buying stocks also generates profits in the form of dividends, where companies distribute a portion of their earnings to shareholders.
Is Spot Trading the Same as Buying?
Spot trading and buying are often used interchangeably, but buying does not cover the charge of spot trading completely. Firstly, a trade is not complete until a sales transaction is made, and profits or losses are realized. Moreover, what differentiates spot trading from “buying” is that it only allows you to use the capital you already have access to. You cannot borrow money from a brokerage or exchange to trade in this market.
What Is the Difference Between Spot Trading and Futures Trading?
As discussed, spot markets allow you to purchase assets with immediate delivery, so you can wait for the price to increase. Futures trading works differently because you do not own the underlying asset. Instead, futures merely represent the value of an asset. When trading on the futures market, you agree to buy or sell an asset on a future date, at a predetermined price.
Contrary to spot trading, futures allows you to short the market and use leverage on your trades. These tools can help you make money in the short term, while spot trading is generally more suited for long-term trading.
When a futures contract reaches its expiry, the buyer and seller usually agree to settle the trade in cash, rather than actually exercising the contract.
Also Read: Trading Futures on Binance: A Complete Guide for Beginners
What’s the Difference Between Spot Trading and Margin Trading?
Where spot traders buy assets with their capital, margin traders borrow capital to purchase stocks or crypto. While this allows them to buy assets in larger quantities, it also forces them to meet margin requirements to avoid a margin call.
Because the costs of a margin loan can pile up, margin traders often trade in a shorter time frame than spot traders. This type of trading is also considered riskier, because a losing margin trade can cost you more than your initial investment.
Types of Cryptocurrency Spot Market
There are two major types of spot markets. Most of you must be familiar with exchanges, where supply and demand are brought together on a single platform. These exchanges allow you to buy or sell assets quickly at the market price.
Using an order book, traders even get information on the amount of Bitcoin available for sale and its demand. It can help them get a better understanding of the available liquidity in the market.
Another type of spot market is found in over-the-counter (OTC) trading. OTC trades happen when a buyer and seller transact directly, without a third party or trading platform to oversee the trade. The two parties may choose to transact assets at any price they see fit, whether below or above the market price.
This type of trade is popular because it lets traders negotiate on multiple items other than price. As an example, OTC markets are a great place to buy a large amount of cryptocurrency, without causing the volatility you would cause by buying on the open market.
What Are the Risks of Spot Trading?
Depending on the market you are trading, there are various risks that traders need to consider. Firstly, liquidity in spot markets can dry up over time. Especially during bear markets, smaller altcoins tend to lose most of their liquidity. As a result, traders may struggle to find a place to sell their tokens for fiat at a fair market price. When there is insufficient liquidity, you will be forced to either sell at a lower price than the market value or hold on to your investments.
Another risk presents itself when you decide to trade commodities on the spot market. For example, if you spot purchase crude oil, you will have to get it delivered physically. Yes, real, physical crude oil will be delivered to you. Finally, because spot trading does not allow for margin, your profit potential is limited.
What Are the Benefits of Spot Trading?
At the same time, the lack of margin in spot trading protects you from losing more capital than you want to. Spot trading is one of the safest ways of investing, allowing you to hold onto your investments without much worry.
Prices of the spot market are very transparent because it is purely based on supply and demand. When trading other instruments, such as derivatives, futures or options, there are multiple other factors influencing price, such as time.
Because spot trading allows you to own assets outright, you do not have to worry about interest payments or maintenance margins. It allows you to buy Bitcoin in 2022, forget about it for a few years, and come back to sizeable profits in 2028 (not financial advice).
No matter your trading approach, make sure you exercise risk management!
Writer’s Disclaimer: This article is based on my limited knowledge and experience. It has been written for educational purposes. It should not be construed as advice in any shape or form.
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