Basis trading is a popular trading strategy across all asset classes where derivative products are available but primarily used in futures trading focused on commodity markets. Basis trading crypto is another sector that experiences an increase in this trading strategy due to its extreme volatility and availability of 24/7 trading.
Before considering basis trading, traders must understand the basis trading definition and the conditions for basis trading strategies to generate profits. We will evaluate basis trading and highlight the opportunities and the risks to help you determine if you should try basis trading.
What Is the Definition of Basis Trading?
Basis trading refers to a trading strategy where one buys an asset and sells a related derivative product or sells an asset and buys the related derivative product. For example, buying gold and selling a gold futures contract or selling oil and buying an oil futures contract. Traders execute a basis trading commodities strategy or any other asset class if they believe the two products remain mispriced concerning each other by financial markets. Another term for basis trading is cash-and-carry trade, and basis trading strategies fall under financial arbitrage.
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Basis Trading - How Does It Work?
Basis trading usually occurs midway through the production cycle of commodities. It also works well with any highly volatile asset with numerous futures contracts, where the price difference of the derivative relative to the spot instrument increases or decreases the further out the expiry date.
Traders can go either long or short, or buy and sell, a basis trade. Basis trading futures strategies account for most basis trading amid the widespread availability of contracts. Commodity trading, more specifically soft commodities, remain ideal for basis trading.
Two Examples of Basis Trading
Below is a basis trading example for a long and short trade to help understand how to place a basis trade in either direction.
1. Basis Trading Long Position
A trader believes the price of gold will appreciate and buys 100 ounces in the spot market at 1,975 and sells a gold futures contract two months out at 2,010. In this basis trading example, the trader anticipated the price difference between the spot contract and the futures contract to grow.
2. Basis Trading Short Position
A trader believes the price for a bushel of wheat will depreciate and sell 100 bushels in the spot market at 11.00 and buys wheat futures contracts two months out at 10.50. In this basis trading example, the trader anticipated the price difference between the spot contract and the futures contract to narrow.
How To Calculate Basis Trading Costs, Profits, And Losses
The trading costs depend directly on the broker, the spread between the bid and ask prices, the commission per transaction, and the financing costs for leveraged overnight positions. Below are examples of profits and losses for a basis trading long and basis trading short position, excluding broker-related charges.
1. Basis Trading Long Position - Profit
- Buy 100 ounces of gold at 1,975 and sell 100 ounces gold futures contract at 2,010
- The cost basis is -35, or the cash price minus the futures price
- The cash price of gold advances to 2,000 and the futures contract to 2,020
- The cash position earns 25, and the futures position loses 10, resulting in a profit of 15
2. Basis Trading Long Position - Loss
- The cash price for gold drops to 1,950 and the futures contract to 2,000
- The cash position loses 25, the futures position earns 10, resulting in a loss of 15
3. Basis Trading Short Position - Profit
- Sell 100 ounces of gold at 1,975 and buy 100 ounces gold futures contract at 1,960
- The cost basis is +15, or the cash price minus the futures price
- The cash price of gold drops to 1,950 and the futures contract to 1,945
- The cash position earns 25, and the futures position loses 15, resulting in a profit of 10
4. Basis Trading Short Position - Loss
- The cash price for gold rallies to 2,000 and the futures contract to 1,980
- The cash position loses 25, the futures position earns 20, resulting in a loss of 5
Basis Trading Futures Explained
Basis trading futures allows producers and consumers to lock in profits or hedge their exposure to future price fluctuations. For example, a corn farmer who anticipates the harvest to result in a surplus, therefore depressing future prices, can sell corn futures before the harvest to lock in profits. A trader would buy corn at cash prices and sell future contracts. Alternatively, a clothing manufacturer who believes cotton prices will rise in three months when supply for the factory requires replenishing can buy futures contracts, guaranteeing delivery prices. A trader would sell cotton at cash prices and buy future contracts.
Futures markets also offer a hedge while lowering the profit potential, ideal for highly volatile markets. Traders must understand that a futures contract is a legally binding agreement to deliver the specified quantity of goods at the time listed on the contract.
The Advantages and Disadvantages of Basis Trading
Traders must consider the advantages and disadvantages of basis trading.
The advantages of basis trading include:
- Price security for producers, consumers, and traders
- Hedge against future price fluctuations
- Decrease in risk
- Availability of leverage
The disadvantages of basis trading include:
- Traders face additional costs
- Decreased profit potential
- Only suitable for active day traders
- Risk of overtrading due to marginal profit potential
What Risks Exist When Basis Trading?
- Misuse of leverage without proper risk management
- Incorrect analysis of assets resulting in taking the wrong basis trading strategies
- Failure to follow through on strict trading plans, especially when faced with losses
- Not closing both positions of a basis trade simultaneously
Basis Trading Conclusion
Basis trading works best in commodity markets, but traders may apply it to any asset with high liquidity, volatility, and availability of futures contracts. Traders must consider the carry costs of basis trading strategies, and basis trading is only suitable for active day traders. While institutional traders experience the most notable benefits, basis trading features numerous disadvantages that outweigh the benefits for most traders. Basis trading is not related to basis price or cost basis.
