Basis Trading: Definition, How It Works, Example

Basis Trading: Definition, How It Works, Example

Definition:

Basis trading is a type of arbitrage strategy commonly used in the futures markets. It involves taking offsetting positions in the spot (cash) market and the futures market for the same or related asset, aiming to profit from the difference between the two prices—called the basis.

• Basis = Spot Price – Futures Price

Traders engage in basis trading when they believe the basis will converge or change in a predictable way over time.

How It Works:

There are two main types of basis trading:

1. Long Basis (Cash-and-Carry Arbitrage):

• Used when the futures price is higher than the spot price (contango).
• Trade:
  • Buy the underlying asset in the spot market.
  • Sell the futures contract.
• At expiry, deliver the asset against the futures contract or unwind both positions.
• Profit: If the basis narrows (i.e., futures price falls or spot price rises), the trader gains.

2. Short Basis (Reverse Cash-and-Carry):

• Used when the futures price is lower than the spot price (backwardation).
• Trade:
  • Sell the asset in the spot market.
  • Buy the futures contract.
• At expiry, repurchase the asset at a lower futures price.
• Profit: If the basis widens (i.e., spot falls or futures rise), the trader gains.

Example:

Suppose a commodity (e.g., crude oil) has:

• Spot price: $90 per barrel
• Futures price (3 months out): $95 per barrel
• Storage cost: $1 per barrel
• Interest cost: $2 per barrel

This is a contango market, as futures are more expensive than spot.

A trader executes a long basis trade:

• Buy crude oil at $90 (spot market)
• Sell a futures contract at $95

Costs: $90 (buy) + $1 (storage) + $2 (interest) = $93
Proceeds at expiration: $95 from delivering on the futures contract
Profit: $95 – $93 = $2 per barrel

Why It’s Useful:

• Used by hedgers (like farmers or oil producers) to lock in margins.
• Employed by arbitrageurs and proprietary trading firms for relatively low-risk profits.
• Common in commodities, treasury bonds, and even cryptocurrency markets.