Basis Trading

It is a financial trading strategy that involves purchasing a particular financial instrument or commodity and selling its related derivative.

Author: Marazban Tavadia
Marazban  Tavadia
Marazban Tavadia
I have completed my Bachelors in Business Administration. I am currently working as a Financial Analyst with Northern Trust and am a trader by the side.
Reviewed By: Patrick Curtis
Patrick Curtis
Patrick Curtis
Private Equity | Investment Banking

Prior to becoming our CEO & Founder at Wall Street Oasis, Patrick spent three years as a Private Equity Associate for Tailwind Capital in New York and two years as an Investment Banking Analyst at Rothschild.

Patrick has an MBA in Entrepreneurial Management from The Wharton School and a BA in Economics from Williams College.

Last Updated:October 20, 2023

What is Basis Trading?

A financial strategy known as basis trading involves purchasing a specific financial instrument, stock, or commodity and then selling the derivative that goes along with it.

This approach is highly widespread among traders, especially in futures commodities markets, attempting to hedge the production costs against the sale of the commodity they predict.

When investors know that two stocks or commodities are not fairly priced and related, they trade based on this information (such as Shares of MFSL and its future contract). This is because they believe the inaccurate value will be changed.

The basis is the distinction between a commodity's current and future cash prices.

The difference between the spot price and the price of a futures contract for the commodity, also known as the basis, is what basis trading is.

The basis for a futures market is the traded commodity's cash price less the futures price. The value of the futures as a hedge is impacted by changes in the connection between the current cash price and the commodity's future price.

Generally, the basis is determined using the nearby futures contract month price unless otherwise specified.

This is the practice of comparing spot and futures contract prices. The discrepancy is referred to as the basis, and futures traders and dealers strive to profit from it. 

The basis is referred to as a long basis if the difference increases and a temporary basis if the difference diminishes. 

Traders should be aware of the definition and the requirements for the same techniques to be profitable before considering them. 

This article will assess basis trading and point out the benefits and drawbacks to help you decide whether you should attempt it or not.

Understanding Basis Trading

A trader who plans to produce a commodity will enter into a futures contract to lock in the trade price for future trading at the price he wants to sell. 

The trader who buys the future contract will anticipate that rising demand will drive up the commodity's price. Basis trade typically takes place when critical commodities goods are involved.

This trading is a common technique in all asset classes where derivative products are offered. However, it is most frequently utilized in futures trading with a concentration on commodity markets. 

Due to its tremendous volatility and availability of 24/7 trading, crypto is another market that is seeing a surge in this trading method.

The basis trade entails purchasing spot cryptocurrency (having a long position) and creating a short position simultaneously using derivatives like options or futures contracts, or vice versa. 

Although the basis may alter due to shifts in supply and demand, it will eventually converge to zero due to the forces of arbitrage.

This is a trading method in which an asset is purchased, a related derivative product is sold, or an asset is sold, and a similar derivative product is purchased. 

For instance, purchasing gold and then selling a contract for its future, or offering oil and then purchasing a contract for its future. 

For miners and holders of long positions (HODLers), the link between spot and futures prices is crucial since it influences their hedging choices. 

The basis is utilized to look for arbitrage opportunities and evaluate the hedging strategy's effectiveness.

If traders feel that two items are still unfairly valued by one another by financial markets, they will implement this strategy for commodities or any other asset class. 

Cash-and-carry trading is another name for basis trading, and these trading tactics are a type of financial arbitrage. It typically takes place in the middle of a commodity's production cycle. 

Example Of Basis Trading

When a merchant saw how good the demand and supply conditions had been three months before delivering the commodity, they would start to worry about a possible price fall caused by an excess of the commodity.

The merchant might sell enough futures contracts to cover the commodity exposure he anticipated selling. 

The merchant could now lock in a price with a +7.5 point basis if the current price of the commodity was $70.00 per gram and the futures contract, which had expired one month out, was priced at $77.5 per gram.

A basis price is an offer concerning a security investment's yield to maturity. Bonds and other fixed-income products typically come with a basic price. An annual rate of return on a bond will be fixed. 

The amount the bondholder may expect to accrue in interest each year is expressed as an annual rate.

This approach is highly widespread among traders, especially in futures commodities markets, attempting to hedge the production costs against the sale of the commodity they predict.

The trader uses this technique when the production cycle is nearly finished and locks in a price for the commodity.

A trader will lock in a price to ensure their trade is not impacted when they believe prices will fall in the future.

The trader on the other side of that position will similarly buy at a higher price than the spot price.

But they will ensure that their contract is sold at the spot price, hedging their bet and engaging in long trade to protect themselves against price fluctuations.

Producers and consumers can hedge their exposure to future price volatility or lock in profits by using this strategy for futures.

For instance, a cotton farmer can sell futures before the harvest to lock in profits if he expects the crop to produce a surplus, lowering future prices. A trader would purchase cotton at spot prices and market futures. 

An alternative is to purchase futures contracts, which guarantee delivery prices if a clothmaker thinks cotton prices will increase in three months when the factory's supply has to be replenished. 

A trader would acquire future contracts and sell cotton at spot prices.

Futures and Risks in Basis Trading

The basis in the futures market displays the discrepancy between the stock's or commodity's cash price and futures price. 

Due to the correlation in the middle of the spot and how futures prices affect the cost of the contracts used to lower risk, it is a critical ironic theory for investors. 

However, the strategy can also be ambiguous because the basis is not always exact. This is because there is a spread between the present and future prices until the futures contract expires.

Futures contracts are made to eliminate or lessen the risk of price volatility. However, the Future contracts are not by nature binding. 

Therefore, the trader entered into the futures contract to cover the risk, and the only loss, if the price of the stock or commodity falls below the price of the contract, is the loss of the premium that was paid at the time of entry.

This difference results from the passage of time between the commodity's spot price and the contract's expiration.

For instance, a corn farmer can sell corn futures before the harvest to lock in profits if he expects the harvest to produce a surplus, lowering future prices. A trader would purchase corn at spot prices and market futures. 

An alternative is to purchase futures contracts, which guarantee delivery prices if a clothmaker thinks cotton prices will increase in three months when the factory's supply has to be replenished. 

A trader would acquire future contracts and sell cotton at spot prices.

Futures markets are suitable for extremely volatile markets since they provide a hedge while reducing the opportunity for profit. 

A futures contract is a legally enforceable promise to deliver the specified quantity of products at the time specified on the contract, and traders must grasp this.

The broker, the difference between the bid and ask prices, the transactional commission, and the financing expenses for leveraged overnight positions all directly affect the cost of trading.

Advantages And Disadvantages Of Basis Trading

Advantages 

The following are the advantages of Basis trade: -

  • A later increase in the price of commodities will not impact investors thanks to the short basic strategy's price security.
  • Based on this strategy, losses can be minimized because a contract can be entered into to guarantee a minimum selling price for the produced product.
  • It aids investors in avoiding price or profit declines.
  • It protects against price swings and guards against further loss if the product's price drops below the level at which it was meant to be sold.
  • It is one of the methods investors use to close out winning positions.

Disadvantages 

The following are the disadvantages of Basis trade: -

  • If the price rises above the future base contract for sale, then it could reduce the earnings
  • Recommended only for regular day traders
  • Decreased likelihood of profit.
  • Since this strategy entails its cost, profits may decline as the cost basis rises.
  • Traders must pay additional expenses.
  • Risk of excessive trading because of low-profit possibilities.

Risks Involved in Basis Trading

The dangers of this trading strategy include that the seller who short-sells the commodity under the futures contract may lose money if the spot price rises above the future contract price.

Suppose a trader enters into a long basis contract, meaning they buy the commodity after a certain period, and the spot price of that commodity drops below the contracted price. In that case, the buyer must bear the loss even though they can buy the commodity on the open market.

Other risks involved are:

  • Basis trading
  • It might reduce earnings because it has a cost of its own.
  • Abuse of leverage without adequate risk management
  • Failure to follow strict trading strategies, especially after suffering losses.
  • Less reward follows naturally from lowering risk.
  • It is possible to manage the portfolio with precise control actively.
  • Not closing the base trade's two positions simultaneously.

Conclusion

According to the observations above, the market's use of futures pricing information is ineffective. Nevertheless, most of the information in futures pricing is still effectively utilized in the case of metals.

It is a reliable approach to guarantee a minimum profit and minimum selling price. It is comparable to trading financial products like futures and options. It is the discrepancy between the current market price and the anticipated price. 

It typically involves selling vital commodities and goods to make a profit. Basis Trading in futures refers to the discrepancy between the cash and futures contract prices.

These trading tactics have carry costs that traders must consider, and strategy is only appropriate for active day traders. 

Although it has several advantages, the downsides exceed the benefits for most traders, with institutional traders enjoying the most significant advantages. Basis pricing or cost basis has no bearing on basis trading.

Even though this strategy carries a significant level of risk, it also manages that risk by securing a minimal selling price. Investors lose money if the selling price rises above the predicted price.

Most market contracts exhibit substantial basis risk, demonstrating that they cannot be used for basis trading. However, since base risk in the case of metals is lower than spot price risk, practically all contracts can lower spot price risk.

Researched and authorized by Marazban Travadia | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: