Basis TradingExplained & Defined

Written By:
Adiste Mae

What is Basis Trading?

A trading strategy called Basis Trading is the difference between the Spot Price (or the cash price of an item today) and the future price of the same financial instrument which can be a derivative or a commodity.

Basis = Cash Price – Futures Price

The difference between the price is called the basis in futures trading.

When the difference is expected to grow, it is referred to as “long the basis” and if it is expected to decrease, it is referred to as “short the basis”.

The other term referred to for Basis Trading is cash-and-carry trade.  

Understanding Basis Trading

For traders who are looking at hedging the costs incurred in production versus the sale of the commodity that they anticipate, this practice is very common, especially in futures commodities markets.

This practice is done when the production cycle has not yet been completed or is near completion and the trader locks in a price for the commodity. 

When a trader anticipates future prices to decline, he or she will lock in a price to ensure that a future decrease in prices will not affect his trade.

This is an example of short the basis.

In the same way, the trader who is on the opposite side of that situation will purchase at a higher price than the spot price but ensuring that their contract was sold at the spot price, their bet would have been hedged resulting in a long the basis trading because this ensures that the trader is protected from the changes in prices. 

Basis Trading in Practice

Agricultural Futures is the most common type of Basis Trading but they are not limited to grains contracts.

Other commodities such as precious metals, indexes, and interest rates products can also be used in Basis Trading. 

Although the different types of commodities present different variables for each, their goal is the same – the opportunity to benefit when the basis amount increases or decreases.

What must also be understood here is that the changes in the basis amount are not related to the supply and demand but rather in the anticipation that a change in basis will happen.

Those who trade in basis trading are ultimately constantly trying to anticipate changes in the expectations in speculators and hedgers.