What is Basis Trading?
The phrase basis trading, in the context of futures trading, refers to trading techniques based on the difference between the spot price of a commodity and the price of a futures contract for that commodity. In futures trading, this disparity is referred to as the basis. If a trader anticipates this disparity to expand, they will engage a “long the basis” trade; if they expect the gap to shrink, they would enter a “short the basis” trade.
- The goal of basis trading is to profit from changes in the basis of futures contract prices.
- The basis is the difference between a commodity’s spot price and a futures contract expiring two or more months later.
- The word “basis” in futures trading should not be confused with the phrases “basis price” or “cost basis,” which have nothing to do with the context of basis trading.
Understanding Basis Trading
Basis trading is widespread in futures commodity markets, as producers seek to hedge their production costs against the expected sale of the commodity. The usual transaction occurs when a company is in the middle of a manufacturing cycle and wants to lock in a good price for their product.
For example, if a corn farmer was two months away from producing a harvest of corn and noted how good the weather had been, that farmer may be worried about a possible price decline caused by an overabundance of grain. The farmer may be able to sell enough futures contracts to cover the quantity of maize he intends to sell. If the market price of corn was $4.00 per bushel and the two-month futures contract was trading at $4.25 per bushel, the farmer could now lock in a price with a +.25 cent basis. At this stage, the farmer is shorting the basis because he expects the price of the futures contract to decline and, as a result, come closer to the spot price.
The speculator on the other side of this deal will have paid 25 cents per bushel more for futures contracts than the current price (the basis).If the speculator hedged their bet by selling contracts at the spot price ($4.00 per bushel), they would now be long the basis. They want to see the current month contract become even less costly compared to the contract that ends two months later since they are shielded from price swings in either way. This speculator may believe that, despite excellent weather and great growing circumstances, consumer demand for ethanol and feed grain will outstrip even the most optimistic supply forecasts.
Basis Trading in Practice
Because of the nature of these commodities, basis trading is widespread in agricultural futures. It is not, however, restricted to grain transactions. Though grain is a real commodity with distinct characteristics, basis trading is also used for precious metals, interest rate instruments, and indices.
The variables alter in each scenario, but the methods remain the same: a trader seeks to profit from a rise (long) or reduction (short) in the base amount. Such shifts are not caused by actual shifts in supply and demand, but rather by the expectation of such shifts. Basis trading is a complicated game in which hedgers and speculators attempt to predict changes in their expectations.
Basis trading, or the basis, as it is defined above in relation to futures contracts, is not the same as the basis price or cost basis of a certain asset. The distinction between these words and a trading basis for futures contracts should not be overlooked.
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