What it means
The basis is simply the cash (spot) price minus the futures price for the same underlying asset. In commodity markets, for example, a grain merchant who owns wheat in a silo watches the difference between the local cash price and the exchange futures price.
That gap reflects storage costs, transport, interest and local supply and demand. A trader who is long on the basis buys the cash asset and sells futures against it.
If prices rise or fall together, the two legs largely offset each other, so the outcome depends on whether the basis strengthens (cash gains on futures) or weakens. A strengthening basis makes money for this position, and a weakening basis loses money.
Businesses use the idea to manage price risk. A farmer storing grain who sells futures is protected against a general price fall but keeps the risk that the local basis will move.
Bond desks and treasury teams do something similar in government bond markets, owning the cash bond and shorting the futures contract. The key nuance is that the basis is not random.
As the futures contract approaches expiry, the basis normally narrows towards zero because cash and futures prices must converge. Traders therefore think about the expected path of the basis and whether the market is pricing it too wide or too narrow today.
Basis positions carry their own risks. Delivery options in the futures contract, funding costs, margin calls on the futures leg and sudden shortages in the cash market can all move the basis against the position even when the overall price level is stable.
In practice
Real-world examples.
Example
A grain elevator operator buys farmers' wheat and sells futures the same day. When local harvest congestion eases and the cash price recovers relative to futures, the elevator earns extra margin on top of its handling fee.
Example
A fixed-income trading desk buys a government bond in the cash market and sells the matching bond futures contract. It expects the futures to look expensive relative to the bond and earns the narrowing gap, financed with short-term borrowing.
Example
A copper fabricator holds refined metal in a warehouse and sells exchange futures against it. If a local shortage pushes the physical premium up, the fabricator gains on the basis even though the headline copper price barely moves.
Formula
Calculation
Basis = Cash price - Futures price
Profit on a long-on-the-basis position = Change in basis x Quantity
Suppose a grain merchant buys 50,000 bushels of corn at a cash price of $4.50 per bushel and sells futures at $4.80 per bushel. The basis is $4.50 - $4.80 = -$0.30 per bushel.
Two months later the cash price is $5.00 and the futures price is $5.10. The basis is $5.00 - $5.10 = -$0.10, so it has strengthened by $0.20 per bushel.
Gain on cash leg = ($5.00 - $4.50) x 50,000 = $25,000.
Loss on futures leg = ($4.80 - $5.10) x 50,000 = -$15,000.
Net profit = $25,000 - $15,000 = $10,000, which equals $0.20 x 50,000 and shows that only the basis change drove the result.Case study
Seen in the real world.
Prairie Gold Milling is an illustrative, fictional flour producer that stores wheat ahead of its busiest season. Its finance manager wanted to remove the risk of a price crash but was told that selling futures would only hedge the level of prices, not the local gap between cash and futures.
She bought wheat at a basis of minus $0.40 per bushel and sold futures against it, deliberately going long on the basis. Over the next three months the local supply tightened and the basis strengthened to minus $0.15, earning $0.25 per bushel on 200,000 bushels, or $50,000, regardless of the flat market price.
In the fictional follow-up year the basis moved the other way and cost the firm $30,000. The story illustrates that the position swaps outright price risk for basis risk, which is smaller and more predictable but never zero.
Watch out
Common mistakes.
- Assuming that being long on the basis means being bullish on the market, when the position is designed to be roughly neutral to the price level.
- Ignoring carrying costs such as storage, insurance and interest, which are a large part of why the basis exists.
- Forgetting the margin calls on the futures leg, which can strain cash even when the overall position is profitable.
Questions
People also ask.
What is the difference between long and short the basis?
Long the basis means owning the cash asset and being short futures, profiting when the basis strengthens, while short the basis is the reverse and profits when the basis weakens.
What does a strengthening basis mean?
It means the cash price is rising relative to the futures price, so the basis moves from a larger negative number towards zero or turns positive.
Does the basis always converge to zero?
At futures expiry it should converge closely, but small differences remain because of delivery location, quality grade and timing.
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