What is Basis Trading?

Basis trading is a way to make money by buying and selling things. A basis trade uses two different things that are related to each other. One thing is bought with cash. The other thing is a futures contract.

Cash Instrument

The thing bought with cash is called the “cash instrument”. A cash instrument can be many different things:

• A real product like crude oil, gold, or corn
• A financial product like stocks, bonds, or currencies

You pay cash and you get the thing right away when you buy the cash instrument.

Futures Contract

The other part of a basis trade is the futures contract. A futures contract is an agreement to buy or sell something in the future at a set price. The price is agreed to now but the actual exchange of money and the thing happens later.

Key points about futures contracts:

• They are for a specific amount of a product
• The price is locked in advance
• The trade settles (completes) on a future date

How Basis Trading Works

The key to basis trading is the difference between the cash price and futures price. This difference is called the “basis”.

The Basis

Basis = Cash Price – Futures Price

The basis can be positive or negative:

• Positive basis: Cash price is higher than futures price
• Negative basis: Futures price is higher than cash price

The basis changes over time as the cash and futures prices move up and down. Basis traders try to predict how the basis will change. Then they trade to profit from the change.

Trading the Basis

A basis trade involves buying the cash instrument and selling the futures contract (or vice versa). The goal is to make money on the change in the basis over time.

Imagine the basis is $10 today. A trader thinks it will get smaller. Here is what they could do:

1. Buy the cash instrument
2. Sell the futures contract
3. Wait for the basis to shrink
4. Sell the cash instrument
5. Buy back the futures contract
6. Profit from the basis change

If the basis shrank to $5, the trader could make around $5 per unit traded (ignoring transaction costs).

Risks of Basis Trading

Basis trading tries to profit from basis changes. But the basis may not change as predicted. This is called “basis risk”.

Basis Risk

There are several reasons the basis might not change as expected:

• Supply and demand for the cash product could change
• Storage costs of the physical product could change
• New information could affect the futures market differently than the cash market

Any of these could cause the basis to change in an unexpected way. The basis could widen instead of shrink. Or it may not change at all.

Managing Basis Risk

Basis traders have to manage their risk. They usually do this by:

• Researching the markets to make good predictions
• Watching the trades closely and reacting to changes
• Using stop-losses to prevent big losses if the basis moves the wrong way
• Hedging the trade with other positions

Managing basis risk is an important skill for a successful basis trader.

When is Basis Trading Used?

Basis trading is often used by:

• Producers like farmers who grow crops
• Users like food companies who buy the crops
• Traders and investors speculating on price changes

Producer Use of Basis Trading

Imagine a corn farmer. They will have a lot of corn to sell at harvest time. But they are worried prices might go down before harvest.

The farmer could use a basis trade:

1. Sell a futures contract locking in a price for their corn
2. At harvest, sell their actual corn
3. Buy back the futures contract
4. The gain/loss on the futures trade offsets the higher/lower price on the actual corn sale

This locks in the farmer’s selling price. It removes price risk but keeps basis risk.

User Use of Basis Trading

A cereal maker needs to buy a lot of corn. They are worried the price of corn will go up by the time they need it.

The cereal company could:

1. Buy a futures contract locking in their purchase price
2. Later, buy the actual corn they need
3. Sell back the futures contract

The futures gain/loss will offset the actual purchase price change. Again, price risk is offset but basis risk remains.

Speculator Use of Basis Trading

Investors can speculate on basis changes without needing the actual product.

For example:

• Buy a crude oil futures contract
• Sell a crude oil ETF that tracks the spot price
• If the futures price rises more than the spot price, the basis has increased

This speculative basis trade has no actual oil involved. The investor only cares about the price difference between the futures and ETF.