Basis Trading: Definition, How It Works, Example

?What is Basis Trading

In the context of futures trading, the term basis trading refers generally to those trading strategies built around the difference between the spot price of a commodity and the price of a futures contract for that same commodity. This difference, in futures trading, is referred to as the basis. If a trader expects this difference to grow, the trade they will initiate would be termed "long the basis", and conversely, a trader enters "short the basis" when they speculate that the 

   .difference will decrease.

 

Understanding Basis Trading

Basis trading is common across futures commodities markets where producers look to hedge the cost of production against the anticipated sale of the commodity they are producing. The typical trade comes when one is midway through a production cycle and looks to lock in a favorable price for their product.

For example, suppose a corn farmer was two months away from delivering a crop of corn and noticed how favorable the weather conditions had been, that farmer might become concerned about a potential price drop resulting from an oversupply of corn. The farmer might sell enough futures contracts to cover the amount of corn he hoped to sell. If the spot price of the corn were $4.00 per bushel, and the futures contract that expired two months out were trading at $4.25 a bushel, then the farmer could now lock in a price with +.25 cent basis. The farmer, at this point, is making a trade that is short the basis, because he is expecting the price of the futures contract to fall and consequently come closer to the 

spot price.

The speculator who takes the opposite side of this trade will have purchased futures contracts for 25 cents per bushel higher than the spot price (the basis). If that speculator hedged their bet by selling contracts at the spot price ($4.00 per bushel), they would now have a position that is long the basis. That is because they are protected from price movements in either direction, but they want to see the current month contract become even less expensive relative to the contract that expires two-months later. This speculator may be expecting that despite the good weather and favorable growing conditions, consumer demand for ethanol and feed grain will overwhelm even the best supply predictions

.

Basis Trading in Practice

Basis trading is common among agricultural futures because of the nature of these commodities. However, it is not limited to grain contracts. Though grain is a tangible commodity, and the grain market has a number of unique qualities, basis trading is done for precious metals, interest rate products, and indexes as well.

In each case the variables are different, but the strategies remain the same: a trader attempts to benefit from an increase (long) or a decrease (short) in the basis amount. Such changes are not related to actual changes in supply and demand, but rather the anticipation of such changes. Basis trading participates in a sophisticated game of trying to anticipate changes in the expectations of hedgers and speculators.

Basis trading, or the basis, as described here relating to futures contracts, is an entirely different concept than the basis price or cost basis of a given security. The difference between these phrases and a futures trading basis should not be confused.

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