Updated July 17, 2023
Definition of Basis Trading
Basis Trading is one of the strategies to earn profit from changes in the basis of the futures contract price of the commodity under the contract and it is nothing but the difference between the spot price and the price of a futures contract of the commodity which is also known as basis.
Basis Trading is the difference between the spot price and the futures contract price. The difference is termed as basis and on that difference, the traders or dealers of futures try to get benefit from it. If the difference i.e. basis increases then it is called a long basis whereas if the difference decreases the basis is called as a short basis. Dealer purchases the future contract in a hope that the basis will decrease and the future contract price will become equal to the spot price of the commodity.
It is like financial arbitrage trading which deals with financial instruments like derivatives or commodities with an intention to earn profit from the deal. It is carried when the trader of a commodity thinks that the price of a commodity is under priced and in the future, it will increase and the trader can earn profit from it. Basis Trading is also referred as cash and carry trade.
How Does Basis Trading Work?
Basis Trading works as under:
Trader who wants to secure the price of trade for future trading of a commodity which he is going to produce will enter into the futures contract for the price at which he wants to sell. The trader who purchases the future contract will hope that the price of the commodity increases due to an increase in the demand. Basis trading happens normally in the case of essential commodity goods.
Example of Basis Trading
Mr. John is the producer of Corns and according to him there will be a greater supply of corns in this year hence the producer become bothered about a potential decrease in the price due to an increase in the potential supply of corns. To ensure that Mr. John will get the correct price of his produce he entered into a future contract of selling the corns after 2 months when his produce will be ready to sell for $ 52. the seller expects the selling price of the market is $ 50. Hence to secure his trade, the trader entered into a future contract for $ 52. it is the example of short sale i.e. short basis.
Similarly, the purchaser or future contract will purchase on the view that if there is large supply of corns there will be greater demand and due to which it can be sold beyond $ 52. purchase is the type of long basis.
Risk of Basis Trading
The risks involved in Basis Trading is if the seller short sell the commodity under the futures contract and if the spot price increases above the future contract price then the seller who short sells have to bear the loss of profit.
Similarly, if a trader enters into a long basis contract i.e. purchases of the commodity after a certain period, and if the spot price of a commodity falls less than the contracted price then the purchaser has to suffer the loss as the purchaser can purchase the commodities from the open market.
Hence the risk involved in the basis trading is slightly high.
Basis Trading Futures
In Future market, Basis is the difference between the cash price and the future contract price of the commodity or the stock. Future contracts are entered into to cover or reduce the risk of price fluctuation. But the Future contracts are not obligatory in nature. Hence the person who entered to cover the risk and if the price of stock or commodity falls below the future contract price only loss to the trader is the loss of premium which was paid at the time of entering into a futures contract.
The variance between future price and cash price generated due to time gap between spot commodity and till the validity of the contract.
Advantages of basis trading are defined as under:
- Loss can be reduced on the basis of basis trading as the person can entered into the contract for ensuring the minimum selling price of the produced commodity.
- The minimum selling price can be secured with the help of Basis Trading.
- It acts as the protection against the price fluctuations and prevents from future loss in case of price gets reduced below it was intended to sale.
- A future increase or decrease in price will not affect the minimum profit of the trader if he enters into basis trading. Hence the risk is to be reduced through basis trading.
Some of the disadvantages of basis trading are as under:
- The profits can be lowered if the price increase above the future basis contract for sale.
- Basis Trading has its own cost hence profit can be decreased as there is an increase in Basis Costs.
- Risk involved is high as there are chances of results which are unfavourable to future contract which decreases the profit.
- Strict Directions to be followed to earn benefit from basis trading.
- Commissions in case of basis trading can increase the cost and ultimately decreases the profit.
Basis Trading is one of the effective way to ensure the minimum profit and minimum selling price. It is like trading of financial instruments in futures and options. It is the difference between the spot price and the future price. Basis trading is generally done in the case of essential commodity goods as well as to earn a profit. In the futures, Basis Trading is the difference between the cash price and the futures contract price. Though Basis Trading involves high risk but at the same time, it also controls the risk by ensuring the minimum selling price. If the selling price increases beyond the future price there is a loss to the investor. To earn the profit, strict directions are to be followed. Minimum selling or buying price can be secured with the help of basis trading, which enhances the confidence of the investors.
This is a guide to Basis Trading. Here we also discuss the definition and how does basis trading work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –