Can't seem to understand the logic of hedging and basis
I'm not quite sure what I'm missing, but suppose the following simplified scenario with no storage costs and financing costs:
Spot price March 1: $10
Futures price March 1 for delivery May 1: $15
Now I know that over time, futures and spot prices converge (for a given delivery date). So let's say two months from now we have:
Spot price May 1: $20
Futures price May 1 for delivery May 1: $20
I'm a trader and in March I lock-in a sale price of $15 by selling May futures and buy at spot for $10. On the same day, I sign a contract with a buyer for delivery on May 1, priced at the May 1 spot (which is unknown in March). On May 1, I earn $20-$10=$10 on the physical trade and lose $15-$20=$5 on the hedge, with a total profit of $10-$5=$5.
Now suppose prices actually decline such that:
Spot price May 1: $5
Futures price May 1 for delivery May 1: $5
Now the profits and losses come out to $5-$10=-$5 loss on the physical and $15-$5=$10 gain on the financial, netting $5.
So in both cases the trader makes a stable cash flow of $5, locked in on March 1. Also in both cases, basis narrows, because spot and futures prices always converge on the contract delivery date.
So what exactly is this basis risk we're always talking about? Does it arise because we don't always close our positions on May 1? For example, we might be using May 1 contracts, but actual delivery date is April 22 and there is suddenly a huge differential between spot and futures (eg. market thinks there is a supply shock that will happen down the line):
Spot price April 22: $20
Futures price April 22 for delivery May 1: $42
Here basis widens from -$5 to -$22, but the trader only makes money when basis narrows. So there is a huge loss due to the futures contract, even though physical prices rise. So my question is, is this type of scenario exactly what we mean by basis risk? If so, is the point basically to have some view on the basis so that, in this example case, we can successfully predict a narrowing basis on a particular delivery date so that we can make money instead of lose money? And if this logic is applied to this specific case, shouldn't the trader basically not participate in the trade if he/she somehow knows precisely what the April 22 spot/futures prices will be (let's say we have a smart analyst who makes this prediction)? That is, it might make sense to do some kind of trade involving different delivery dates and futures contracts, but there is no way to make the particular trade I mentioned profitably while using a hedge (since there will be a huge loss in the hedge). Also, doesn't this example also indicate that a trader always wants a narrowing basis if we assume he/she buys and sells based on the spot price?
Thanks for those who got through the post and hope to gain some understanding on this!
I'm having a hard time understanding the scenario you're trying to describe. You're mixing up index deals, EFP/diff deals, and flat price deals which makes none of your math make any sense. You're also not really understanding contract month expiries and CME delivery requirements.
Yea, I'm moving into a role in the industry soon but have no experience yet whatsoever. I'm just very confused by everything based on the few resources I've been able to get my hands on (eg. CME has a guide on how a farmer should hedge to teach about future and spot prices converging). I managed an A in my derivatives class but it certainly gave no examples about physicals.
Would the following be correct? (1) index deal: Haven't been able to find any info on this, but is it related to pricing a contract based on an unknown, future index price? eg. I buy at $5 now and agree to sell to a counterparty at future Brent+5% (2) EFP deal: this is the "deliver to screen" as you talk about below, where the trader buys oil and sells the future. At the delivery date, the trader closes out the contract by actually selling the oil at the futures price, instead of what we talk about in derivatives class where we buy back the contract. (3) flat price deal: no hedging is involved, so I buy the oil for $5 and perhaps agree with a counterparty to sell at $6.
Also, are there basically multiple ways to settle trades each time? For example, if I bought oil at $5 and sold the future at $10, intending to sell to a counterparty, could I end up delivering into the screen instead while buying the commodity at the spot to satisfy my contract?
Yes you’re getting mixed up with the whole convergence thing. You can’t just magically buy spot and sell a future to lock-in profit. In fact, delivering physical to the futures contract delivery will be a guaranteed loss 98% of the time
The basis will never trade below the cost to deliver it to the board. To take your example, numbers, pretend today is April 1st and the futures delivery date is May1st.
Spot price is $10 (basis is -5 vs future) Futures price is $15 Cost to transport to futures delivery warehouse and storage is $7 If you get stuck holding your physical position and are unable to sell it, you can transport it to delivery point for the short futures contract and you will take a -$2 loss. This is your max possible loss
Now imagine the below scenario:
On April 7th The future price drops to 10 A buyer comes in and will pay $9 for the physical delivered to his location. Your shipping cost to the port is $2, which is equivalent to a basis of -3 (9 cash price - 2 shipping, and you bought your initial physical at a basis of -5) You make the sale and buy back you futures contract at $10
Your total pnl from the futures contact is $15 -$10 =$5
Your pnl on cash is -$10 you paid, $9 you sold for and -2 for shipping. -10+9-2 = -3
Net you make $2 on this transaction
That's patently false. Crude and products you can generally buy the screen and sell the cash or vice versa if you can make and take delivery.
Say first month contract is trading $10. Prompt cash is trading front month -2.00 or $8. You buy the cash and sell the front month. You are now long basis at -2.00.
Now, assume you have a tank and can take the contract into expiry. You'll just deliver into the screen out of your tank to the customer and make $2.00 minus your costs.
Now, assume a scenario where you don't have a tank. The above market condition would normally play out a few ways on the cash and board spreads, but for simplicities sake, let's just accept 2 sub-scenarios:
Everyone who can deliver to the screen should bid the cash (theoretically pushing it up) and sell the screen (theoretically pushing it down). This is the convergence you're talking about where the cash should go flat to the screen. In this instance, basis goes from -2.00 to 0 so you make $2.00 on your basis position which you'll now be able to sell flat to the screen. You should see some flat price action on this as well but you're not exposed to it which is the point of hedging. Other signals might move flat price in a way that ignores how the cash is trading.
Imagine tanks are very full or there are other arbs that land cheaper than -2.00. Since you can't deliver to the screen, you still have to sell the cash at a price someone will take it for. In this instance, lets say someone can land -3.00 so they'll offer -2.25 and it trades -2.50. In this instance, you'll lose .50 on basis. Obviously this can play out different ways, but lets say fundamentally, with an open arb, flat price and basis should both get pushed down because people will send product to that market. Since you've already sold the futures, you're only exposed to the cash differential.
This explanation isn't complete without going into a backwards market but hopefully this makes sense for now. I don't agree with the other poster but perhaps he's probably still learning and looks to be an analyst and not a trader.
Is this a correct understanding of scenario 1 of no tank?:
You're the first to notice that cash is 8 and screen is 10, but you can't store the oil and have to sell promptly, Now other traders who can store start noticing it, so they start bidding to buy immediately which drives up the 8 to say 8.5 then 9. At the same time, they lock in their price by selling the futures contract, which drives down the 10 to say 9.5 then 9. Since you were long the oil and short the screen, you sell to one of these traders at $9 immediately while buying back your contract at $9 as well. Thus, you net out $2.
For scenario 2, two questions: - what does "land cheaper than -2.00" mean? Would it mean there's a more profitable trade, such as using a futures contract with a further expiry date, eg. instead of cash 8 screen 10, there is a cash 8 screen 12? - by saying the other trader "can land -3.00" while paying -2.50, does that imply the trader is already short the commodity while long screen with a basis of -3? I think i'm obviously wrong, because I can't work out how that trader would make a profit if the basis is widening (from -2.5 to -3)--wouldn't they lose -0.5 as well?
In your second point, a trader is taking a view on basis. Long physical and short cash is called a long basis trade. You can do the exact opposite though and do a Short basis trade.
To short basis imagine below scenario
The futures price is $15 Spot price is $10
You find a physical buyer today who is willing to pay $12 for physical delivered in 1 month and the cost to transport is $2, so a basis of -5
If you make this sale, you go out and BUy a futures contract at $15 to hedge.
In this case you’re taking a speculative view on basis that it will widen. If futures spike to $30, there should be less demand for physical, so cash prices should drop to the theoretical minimum wish is $23 a basis of -7 (since in previous example it cost $7 to transport to the delivery warehouse)
Your net pnl is 30-15= $15 for the futures contract and $12-23-2=-13 for the physical. Net profit is $2
Hey dude - these aren't very accurate descriptions and betray a tenuous understanding of fundamentals. The nomenclature you use also raises some questions. Cash and Physical are synonyms man.
You're complicating this by only thinking in terms of arbs (which is common), but you're also suggesting that high flat price equates to low demand. I think you're trying to say that cash and the contracts should moderate each other which is true, but you're outlining (at best) dubious mechanics that would actually cause it.
Way to be condescending, obviously there are other markets than just oil that work differently so let me educate you.
When the futures price rallies, in general, more farmers tend to want to sell their crops, and there tends to be less demand from buyers, the reverse tends to happen when prices fall. Especially the case in today’s algorithmic/global markets driven world where prices are completely divorced from fundamentals. Maybe in a theoretical econ101 world physical supply and demand drive the futures, but this isn’t the case for the past 7 years and i have the data to prove it
This is also the case when you use intraday vol to your advantage if your customers are flat price sensitive. If futures price is at 15 and your customer will buy at 12, but your target to sell is -2.5 you can ask your customer to let you work an order at 12 for the day. If the futures drop to 14.50 intraday for whatever reason, you can get them done on their order
I re-read your posts and have to completely redact my apology.
I cannot overstate the joy I would experience if I were to learn that a counterparties trading strategy were based on an understanding as bumbling as the one you've outlined. On behalf of other participants in your market - please stay solvent.
There’s really no need to be such a dick, The op asked why physical traders bother to hedge to trade basis so i gave a simple example where the futures leg makes money and results in profitable physical trade due to the true hedge ratio being
Yes, that's what synonym means. I'm quoting "Long physical and short cash is called a long basis" which, now that you're agreeing, says "long cash and short cash means long basis". Obviously this is nonsense.
Don't work in agriculture, but how is it possible that there is price action without price action? That is to say that there need to be bids to drive the price up.
It sounds like what you're talking about is the relationship between flat price and cash values in markets outside of the merc delivery. Most people would argue that these are even more fundamental but at least this fits your scenario where there should be a negative relationship between flat price and basis.
Either way, trying to not get into debates and dignify responses that seem uninformed. Also, agriculture is a different product that I don't understand the intricacies of. What I can say is that I would be quite surprised if basic market functions don't apply to something as fundamental as agricultural products. I do find the less sophistication the shop has, the more they tend to think of things in terms of flat price, so that might explain why you understand it this way.
I think you could’ve figured out it was a typo that should’ve said long cash short futures considering i listed an example below. Also i spent several years at a top physical house before moving to a hf.
“How is it possible that there is price action without price action?”
-you don’t think Futures prices can rally without fundamental demand in the cash market? Come on. If China PMI data comes out strong overnight and it’s risk on, and Copper is up 4%, em fx strengthening and the yield curve curve bear steepening with inflation breakevens getting paid, i can almost guarantee you the entire commodity complex will be rallying. If you see a move like this in soybeans/corn/coffee/cotton You’ll see producers more willing to sell physical to take advantage of the increase in flat price, and you can buy at a cheaper basis than you could the day before
Fair enough and agreed. I think it adds a degree of complexity to the question that's best to leave off. I try to answer most questions on this board as within a fundamental S&D vacuum as I can draw up.
Sorry for the confrontational tone, I used these boards earlier in my career and the amount of bad information that can digest inside someone who doesn't have another resource to check against is something that I think can do some real damage in interviews. I like to see someone who can understand the simple pieces of the market simply and let them learn about when fundamentals break down since each time they do feels anecdotal.
Another perfect example in support of your point is the entire energy futures complex this past week. Massive tourism into energy positions based on headlines ripped most spreads despite fundamentals as bearish as you like. This was reflected shockingly 1:1 in a lot of cash markets where products have gotten so cheap, there is a flat price element that had to be considered as the cash price just wants to stay around the same value and basis is doing the work every day against flat price to keep it there.
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