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Basis - Definition
In futures trading, Basis is the difference between futures price and spot price.
Basis - Introduction
Basis, also known as "Cash Futures Basis", is one of the most important pricing concepts to understand in futures trading. You might have noticed that futures prices are always higher than or lower than the prevailing price of the underlying asset (Spot Price) and this price difference changes with futures contracts of different expiration months. This price difference between futures price and spot price is known as the "Basis". Basis is an important concept to understand because it gives rise to a few price behaviors which are unique to futures trading and can affect your profitability.
This tutorial shall explore in depth what Basis is in futures trading, how it occurs and how it affects your futures trading.
What Is Basis?
Basis is basically the difference between the price of a futures contract and the price of its underlying asset. Futures prices reflect fair future value and future price expectation of the underlying asset and that is why futures prices will never be the same as spot price. For instance, the spot price of a commodity is $100 but the price of its futures contract expiring in a year may be priced at $110 due to the cost involved in storing the physical asset over that period of time. The difference between the spot price of $100 and the futures price of $110, which is $10, is the basis of that futures contract.
Basis is simply the difference between futures price and spot price. As such, the formula for basis is:
Basis = Futures Price - Spot PriceIn the commodities futures market, basis is more commonly taken as the difference between spot price and futures price. As such, the formula would become:
Basis = Spot Price - Futures Price
Effects of Basis
Basis, which is basically imperfect price tracking between futures price and spot price, becomes a source of risk for futures traders seeking to hedge exposure on the underlying asset using futures or futures traders seeking to profit from speculating in small price changes in the underlying asset. This risk is known as "Basis Risk".
Due to the presence of "Basis", futures prices will not move exactly dollar for dollar with changes in the price of the underlying asset as basis also increases or decreases continuously due to various reasons. In fact, futures contract always move more or lesser than spot price in terms of percentage. There might even be situations in which an underlying asset posts a small gain but its futures contract actually moves lower. This uncertainty resulting from basis is what gave rise to basis risk.
Learn more about Basis Risk.
Basis also affects how you roll forward your futures position. A positive basis will result in rolling forward to a more expensive position resulting in deleveraging while a negative basis will result in rolling forward to a cheaper position resulting in more leverage.
What Causes Basis?
Basis occurs due to the need to prevent arbitrage between the spot price and futures price and reflects futures trader's expectation of future spot price. The specific reason why basis occurs is different for different markets. In the commodities market, basis reflects the cumulative storage costs and other costs related to holding the physical asset all the way to the futures expiration date, also known as the "Cost to Carry". This is why futures price is usually higher than spot price in the commodities futures market. In index futures market, basis reflects the higher dividend you will recieve by buying the whole basket of stocks versus buying the futures and keeping the remainder in cash for interest. In this case, it is a disadvantage to own the futures and hence a lower futures price versus spot price. In the stock market, futures price can be higher or lower than spot price depending on expectations of where the stock price might be in the future.
However, there is no rule or regulation stating how much basis should be for each market. Basis occurs and changes through the trading actions of the futures traders involved and because any significate deviations from the fair value due to the simplistic reasons stated above as well as other more complex ones, results in the possibility of arbitrage, futures arbitrageurs would have stepped in and arbitraged the deviation away. As such, it is the combined actions of all kinds of futures traders; Arbitrageurs, Hedgers and Speculators, that created basis as a reflection of the fair future price with little to no chances of arbitrage.
Basis can also change drastically due to sudden, unforeseeable, change in the fundamentals of the underlying asset itself. Changes such as sudden decline in production capability or supply glut can affect futures price, and hence basis, beyond the simplistic concerns outlined above.
Characteristics of Basis
Since basis is an inevitable phenomena in futures trading, we need to understand how basis behaves and what its characteristics like in order to better understand the behavior of the trades we make when trading futures.
Positive and Negative Basis
Basis can be either positive or negative (also depending on the specific formula being used). Using our first formula, when futures price is higher than spot price, it is known as a Positive Basis and when futures price is lower than spot price, it is known as a Negative Basis. Basis for commodities futures or single stock futures tend to be positive while basis for index futures tend to be negative. There are instances also where basis is positive for the near term but negative for deffered contracts and vice versa depending on the inclination of the market.
Normal and Inverted Basis
Basis could either become more and more positive or negative as expiration month increases. When basis becomes more and more positive with longer expiration, it is known as a "Normal Market". Normal markets normally occur in commodities markets where cost of storage becomes higher with longer expiration. When basis becomes more and more negative with longer expiration, it is known as an "Inverted Market". Inverted markets normally occur in the index futures market where more and more interest is foregone with longer expiration.
Changes in Basis
Basis is volatile and tend to change with changes in the spot price due to the dynamics of futures traders moving futures prices along with changes in the spot price. As such, basis tend to widen (known as "Strengthening of the Basis") or shrink (known as "Weakening of the Basis") throughout the trading day and result in "Basis Risk" for futures traders speculating in basis itself. Due to the changing nature of basis, basis also acts as a buffer between futures price and spot price such that futures price and spot price rarely move in exact amounts in terms of percentage.
Convergence with Spot Price
Futures prices must converge with spot price upon expiration of the futures contract. As such, basis tends to weaken as expiration approaches even if spot price remains stagnant. When basis weaken downwards towards a lower spot price, this price movement is known as "Contango". When basis weaken upwards towards a higher spot price, this price movement is known as "Backwardation".
The uncertainties posed by the above characteristics result in what is known as "Basis Risk". Basis risk is the risk that is inherent in all futures contracts and introduces uncertainty of short term outcome to all kinds of futures trading activities; Arbitrage, Hedging and Speculation. Basis risk arises primarily due to short term uncertainties surrounding the level of basis and the imperfect price track of the underlying asset that results.
As basis can change within predeterminable limits or change seasonally, there are also sophisticated futures traders who speculate directly in the increase or decrease of basis through the use of futures spreads or futures arbitrage techniques. The seasonal change in basis for certain commodities like wheat can be extremely predictable and are the favorite candidates for basis trading.
Basis is an important consideration for producers of a commodity due to the fact that the basis accounts for the basic costs of production and storage of a commodity. A reduction in basis can result in a loss for producers as the production costs and storage costs may be fixed and already paid for all the way to delivery date. On the other hand, widening basis is a risk for buyers of the commodity. As such, an instrument known as "Basis Contract" was created in order to fix the basis between buyers and sellers so as to hedge against basis risk for both parties.