What it means
The basis is the cash price minus the futures price. CME Group explains that it can be positive, called over, or negative, called under, and that a basis moving higher is called stronger while one moving lower is called weaker.
A hedger who is long the basis owns the physical commodity and is short futures, while a hedger who is short the basis does the reverse. Investopedia describes the short side as a short position in the commodity and a long position in the futures contract.
The typical user is a buyer who will need the commodity later, such as a food maker, a feed mill or an exporter that buys futures now to fix the flat price part of its cost. The buyer still carries the basis, because the cash price paid later equals the futures price plus the basis on that day.
That makes the effective purchase price equal to the original futures price plus the final basis, adjusted for the futures gain or loss. A weaker basis lowers the cost, and a stronger basis raises it, so the hedge replaces flat price risk with the smaller basis risk.
Futures prices converge toward cash prices as the contract nears delivery, which is why basis risk is smaller than outright price risk. Most futures contracts are closed out before delivery, and only a small share go through physical delivery.
Basis moves with local supply and demand, transport costs, storage and quality. Investopedia notes that many areas have times of year when the basis is low and times when it is high, so basis traders compare the current basis with its usual level for the time of year.
The term is used mostly in agricultural and energy markets, and contract specifications, delivery points and margin rules differ by exchange, so a hedger should read the current contract terms. A hedge also needs margin and can lose money on the futures leg when prices fall.
In practice
Real-world examples.
Example
A fictional grain buyer needs 50,000 bushels in the autumn and buys December futures at $6.00 in June. The buyer expects a basis of -$0.30 at purchase, so the expected cost is $5.70 ($6.00 - $0.30). That is the plan before any price move.
Example
Futures rise to $6.80 and the basis at purchase is -$0.50, a weaker basis. The cash price is $6.30 ($6.80 - $0.50), and the futures gain of $0.80 reduces the net cost to $5.50. That is $0.20 below plan, or $10,000 on 50,000 bushels.
Example
Futures again rise to $6.80, but the basis at purchase is -$0.10, a stronger basis. The cash price is $6.70, and after the $0.80 futures gain the net cost is $5.90. That is $0.20 above plan, or $10,000 more over 50,000 bushels, even though the flat price hedge worked exactly as intended.
Formula
Calculation
Basis = Cash price - Futures price. Net purchase cost = Cash price paid - Futures gain. Basis effect on cost = Final basis - Expected basis.
Worked example, using a fictional buyer of 50,000 bushels. In June the buyer buys December futures at $6.00 and expects a basis of -$0.30 at purchase, so the planned cost is $6.00 - $0.30 = $5.70 a bushel.
In the autumn, futures have risen to $6.80 and the cash price is $6.30. The final basis is $6.30 - $6.80 = -$0.50. The futures gain is $6.80 - $6.00 = $0.80 a bushel, so the net purchase cost is $6.30 - $0.80 = $5.50.
The basis effect on cost is -$0.50 - (-$0.30) = -$0.20, a saving of $0.20 a bushel. Across the whole order that is $0.20 x 50,000 = $10,000 below plan.Case study
Seen in the real world.
This case study is fictional and illustrative. Amara, 47, runs a feed mill in Nairobi and plans to buy 50,000 bushels of maize later in the year. Her main worry is that prices rise before she buys. She buys futures to fix the flat price, and she checks the usual local basis for the month.
She sees that the basis is normally weakest at harvest. She plans to buy the physical maize at harvest, when the basis is typically weak, and to close the futures at the same time. She also holds back a margin reserve for the futures account. The basis ends close to normal, and her net cost is close to plan.
She learns the hedge protected her from the price rise, but not from a surprise in the local basis. In numbers, she bought futures at $6.00 and expected a basis of -$0.30, a planned cost of $5.70 a bushel, or $285,000 for the order. At harvest futures were $6.50 and the basis was -$0.35, so the cash price was $6.15 and the futures gain was $0.50, leaving a net cost of $5.65 a bushel. That is $0.05 under plan, a saving of $2,500 across 50,000 bushels, and it was the weaker basis rather than the futures position that delivered it.
Watch out
Common mistakes.
- Treating a basis hedge as a full removal of risk when basis risk remains.
- Mixing up long the basis and short the basis, which reverses the gain and loss direction.
- Forgetting margin calls on the futures leg when prices move against the hedge.
Questions
People also ask.
What does short the basis mean?
It means holding a short position in the physical commodity and a long position in futures, which gains if the basis weakens.
How is it different from long the basis?
Long the basis is the reverse: long the physical commodity and short futures. It gains when the basis strengthens.
What is basis risk?
It is the risk that the gap between cash and futures prices changes in a way you did not expect. It remains after a hedge.
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