Understanding the term basis and basis finance is essential for every trader, and we will outline why it matters. Basis can refer to three distinct terms in finance, one referring directly to trading costs, another associated with a trading strategy, and one essential basis definition finance with tax implications and potential fines if not reported accordingly. We cover all three below to help you distinguish between them and look at basis risk and how basis hedging might benefit your trading.
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What Does Basis Refer to In Finance and Trading?
The basis finance definition refers to the difference in the price of an asset and expenses associated with its transaction. It is essential for tax purposes and associated with the terms cost or tax basis.
The three usages of basis are:
- In finance, basis is the total cost of an investment or trade
- In trading, basis is the price difference between an asset in the spot market and an associated derivative, most commonly a futures contract
- For tax purposes, basis refers to the cost associated with an asset
How Does Basis Apply in The Futures Markets?
Basis, or basis trading, in the futures market is the difference between an asset price in the spot market and related futures contracts. The relationship between both offers traders a value perspective when basis hedging, which is crucial for producers and consumers of commodities. Traders must understand that the basis lacks accuracy amid price gaps until the nearest futures contract expires. Basis trading is an arbitrage trading strategy suited for active day traders.
How is basis calculated?
The calculating of basis is straightforward but differs for basis cost, basis trading, and tax basis. Below are examples illustrating them.
1. Basis cost calculation
- The price of an asset is $15, and a trader buys 100 units
- $15 (asset price) x 100 (units) = $1,500 (basis cost)
2. Basis trading calculation
- The spot price of an asset is $50, and the price of a related futures contract is $54
- $50 (spot price) - $54 (futures price) = -$4 (basis)
- When the spot price is below the futures price, the market is in contango
- When the spot price is above the futures price, the market is normal backwardation
3. Tax basis calculation
- The price of an asset is $15, and a trader buys 100 units, while the commission is $10
- $15 (asset price) x 100 (units) = $1,500 (basis cost)
- $1,500 (basis cost) + $10 (commission) = $1,510 (tax basis)
What Is the Definition of Cost Basis?
Cost basis refers to the total cost of an investment or trade, adjusted for dividends, splits, or return of capital distributions. Cost basis has a notable impact on investors who reinvest dividends or capital gains distributions. It increases the cost basis, lowers capital gains, and decreases the taxable amount. An incorrect cost basis when filing taxes can result in double taxation on reinvested capital.
Cost basis calculations can follow the below principles. Each one results in a varying cost basis for the same transaction, impacting profits, losses, and taxable amounts. In our example, a trader buys 500 units of an asset at $15, 800 units at $17, and 1,200 units at $9.
- The average cost basis is ($7,500 (500 units x $15) + $13,600 (800 units x 17) + $10,800 (1,200 units x $9)) / 2,500 (total units) = $12.76
- Assuming the trader sells 2,500 units at $14, the cost basis using the average cost is $35,000 (2,500 units x $13) - 31,900 (2,500 units x $12.76) = $3,100
- FIFO Method Cost Basis = -$2,500 (($14 - $15) x 2,500))
- LIFO Method Cost Basis = $12,500 (($14 - $9) x 2,500))
- High-Cost Method Cost Basis -$7,500 (($14 - $17) x 2,500))
- Low-Cost Method Cost Basis $12,500 (($14 - $9) x 2,500))
How Is Basis Risk Defined?
A trader who buys an asset and sells a related futures contract engages in basis hedging and accepts a basis risk, replacing price risk, the risk that price action moves in the opposite direction of the trade. Basis risk refers to futures prices not moving in unison with spot prices. It can magnify losses and negate basis hedging. The worst-case scenario for traders results in losses on the cash asset and the futures hedge.
What Are the Categories of Basis Risk?
Besides the basis risk associated with price fluctuations noted above, traders may face three additional basis risks.
The three categories of basis risk besides price are:
1. Location basis risk appears when basis hedging covers a futures contract listed on a different location as the spot asset. For example, a trader buys an oil contract in London and hedges it with a futures contract in Singapore.
2. Calendar basis risk refers to the difference in expiry dates for the spot contract and the futures contract. For example, a trader buys a spot contract in April and sells a futures contract for September.
3. Quality basis risk applies when the quality of the assets in the spot contract differs from the quality of the assets in the futures contract. For example, a trader buys light sweet crude oil and sells sour crude oil.
Strategies To Minimize Basis Risk
Traders can never eliminate risk, but they can lower it to acceptable levels while keeping rewards attractive.
Strategies to minimize basis risk include:
- Accurate analysis of assets, driven by facts rather than emotions, opinions, or popularity
- Basis hedging in the location of the spot asset
- Avoiding distant futures contracts where the price relationship breaks down
- Ensuring futures contracts match the asset quality of the spot contract
- Diversification across assets
- Options contracts may offer additional risk mitigation but result in complex trading strategies
Basis Finance Conclusion
Traders must understand basis finance to manage basis risk accurately, apply profitable basis hedging, and optimize tax returns. Basis always deals with price and costs but has three applications, and traders must know when to use them accordingly. Understanding the basis finance definition will improve long-term trading results, impact taxable amounts, and lower the overall risk profile of portfolios at the expense of profit potential.