Basis trading
Encyclopedia
Basis trading is a trading strategy usually consisting of the purchase of a particular security
and the sale of a similar security (often the purchase of a security and the sale of a corresponding futures contract
).
Basis trading is done when the investor feels that the two securities are mispriced with respect to each other, and that the mispricing will correct itself such that the gain on one side of the trade
will more than cancel out the loss on the other side of the trade. In the case of such a trade taking place on a security and the futures contract, the trade will be profitable if the purchase price plus the cost of carry is less than the futures price. It is also called cash and carry
trade.
for each contract. Usually, basis is defined as spot price minus futures price, however, the alternative definition, future price minus spot, is also used.
Adhering to the usual definition, if the basis for each contract is positive and increasing with tenure, the market is in backwardation
. If the basis for each contract is negative and decreasing with tenure (increasing in absolute value) then the market is in contango
.
Successful basis trading favorably balances the futures contract and the cash movement associated with the contract. It is with this in mind that traders analyze the activity level of prospective securities. As part of the approach the deal is put together with a long cash position matched with a short position on the futures. In a sense, what is happening is that the investor is buying cash and carrying it to the futures date, where it will be delivered into the contract.
It is also possible to position a sale in the same manner as the purchase described above. Again, basis trading involves the combination of the long cash position and the short futures. Money for financing the long position can be borrowed and repaid, using the investment as the collateral. Whether buying or selling, traders work to maintain a favorable balance that best allocates the given financial resource to maximize profit. The best profits are produced when there is a chance to sell just before the futures date arrives. Generally, this allows the investor to take his profit and roll the principal over into another trade.
and a put option
. Also referred to as the reversal/conversion rate, it is calculated by determining the cost
s and benefits
of being long
or short the underlying security.
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
and the sale of a similar security (often the purchase of a security and the sale of a corresponding futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
).
Basis trading is done when the investor feels that the two securities are mispriced with respect to each other, and that the mispricing will correct itself such that the gain on one side of the trade
Trade
Trade is the transfer of ownership of goods and services from one person or entity to another. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and...
will more than cancel out the loss on the other side of the trade. In the case of such a trade taking place on a security and the futures contract, the trade will be profitable if the purchase price plus the cost of carry is less than the futures price. It is also called cash and carry
Cash and carry
Cash and carry may refer to:*Cash and Carry , the first network-televised game show*Cash and carry , a revision of the Neutrality Acts, designed to aid the British...
trade.
Basis of futures
Basis of futures can be defined as the difference between the spot price and the futures price. There will be a different basis for each delivery monthDelivery month
For futures contracts specifying physical delivery, the delivery month is the month in which the seller must deliver, and the buyer must accept and pay for, the underlying. For contracts specifying cash settlement, the delivery month is the month of a final mark-to-market...
for each contract. Usually, basis is defined as spot price minus futures price, however, the alternative definition, future price minus spot, is also used.
Adhering to the usual definition, if the basis for each contract is positive and increasing with tenure, the market is in backwardation
Backwardation
Normal backwardation, also sometimes called backwardation, is the market condition wherein the price of a forward or futures contract is trading below the expected spot price at contract maturity. The resulting futures or forward curve would typically be downward sloping , since contracts for...
. If the basis for each contract is negative and decreasing with tenure (increasing in absolute value) then the market is in contango
Contango
Contango is the market condition wherein the price of a forward or futures contract is trading above the expected spot price at contract maturity. The resulting futures or forward curve would typically be upward sloping , since contracts for further dates would typically trade at even higher prices...
.
Successful basis trading favorably balances the futures contract and the cash movement associated with the contract. It is with this in mind that traders analyze the activity level of prospective securities. As part of the approach the deal is put together with a long cash position matched with a short position on the futures. In a sense, what is happening is that the investor is buying cash and carrying it to the futures date, where it will be delivered into the contract.
It is also possible to position a sale in the same manner as the purchase described above. Again, basis trading involves the combination of the long cash position and the short futures. Money for financing the long position can be borrowed and repaid, using the investment as the collateral. Whether buying or selling, traders work to maintain a favorable balance that best allocates the given financial resource to maximize profit. The best profits are produced when there is a chance to sell just before the futures date arrives. Generally, this allows the investor to take his profit and roll the principal over into another trade.
Basis of options
In option trading, basis is used to evaluate the value differential between a call optionCall option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
and a put option
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
. Also referred to as the reversal/conversion rate, it is calculated by determining the cost
Cost
In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this...
s and benefits
Cost-benefit analysis
Cost–benefit analysis , sometimes called benefit–cost analysis , is a systematic process for calculating and comparing benefits and costs of a project for two purposes: to determine if it is a sound investment , to see how it compares with alternate projects...
of being long
Long (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
or short the underlying security.