Let's talk about Basis
Basis Trades, Changes and Risk
Today I will dive in about basis, changes in basis, how to trade basis changes and basis risk.
Basis is a measure of the difference between cash and futures prices.
Basis = spot price - futures prices
The term basis can also be used to describe the difference between two futures prices (eg, March futures versus June).
In contango markets, the futures price is greater than the cash price, so the basis will be negative.
In backwardation markets, the futures price is less than the cash price, thus the basis will be a positive number.
Because of convergence, in both types of market the basis must narrow to zero as the contracts move towards expiry.
In a perfect market, the basis should reflect the cost of carry and the future would always trade at its fair value. Markets are not perfect and the actual difference is usually influenced by short-term supply and demand pressures. It is highly unlikely that the future will be trading exactly at its fair value at any moment in time.
Basis can change as a result of…
Changes to cost of carry, e.g, insurance costs, dividend yields, interest rates
Changes in supply and demand
Changes in time remaining to expiry (convergence)
The reason of this post is that movements in basis can impact hedging strategies but correctly anticipating the changes in basis can provide profitable opportunities.