The key to effectively using commodity futures is understanding the basis. Basis helps determine the optimal timing for buying or selling, choosing the right time to hedge, and selecting the appropriate futures month for placing a hedge.
What Is Basis?
Basis is the difference between the local cash price of a commodity and the price of the corresponding futures contract at any given time.
While both prices generally move in the same direction, they do not always move by the same amount.
Let’s have a look at an example.
| Local cash price | $3.00 |
|---|---|
| January futures price | – $3.15 |
| Basis in January | – $.15 |
Here, the cash price is $.15 lower than (“under”) the January futures price. In the day-to-day speech of futures trading, you could simply say, “the basis is 15 under January.” Conversely, if the local cash price was $.15 higher, the basis would be 15 over January. The basis calculation is simple:
Basis = cash – futures
Basis is often a negative number due to costs like carrying or storing physical commodities. These carrying charges apply only to storable and deliverable commodities, such as wheat, corn, cotton, coffee, gold, and copper.
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Commodities that are not storable and lack carrying charges include live hogs and live or feeder cattle. Other commodities, like sugar or foreign currencies, do not fit neatly into standard categories and require individual analysis. Generally, under normal market conditions, cash prices for these commodities are lower than nearby futures prices.
As the delivery date for futures contracts approaches, the price difference between cash and futures prices often narrows, or converges.
Graphical Representation of Negative Basis in a Normal Market
The largest component of carrying charges is the financing cost. It is generally assumed that the funds required to buy and hold the cash commodity are borrowed. Even if the money is not actually borrowed, there is an opportunity cost, as the funds could be invested elsewhere. The borrowing cost used in calculating carrying charges is typically based on the prime rate.
What is convergence?
The gap between the futures price and the cash price is known as the basis, which typically converges to zero as the delivery date approaches.
Take a note! A negative basis, often called ‘cash under futures,’ indicates that cash prices are below the futures prices. Conversely, a positive basis is referred to as ‘cash over futures,’ meaning cash prices are above the futures prices.
Strengthening Basis
A strengthening basis occurs when cash market prices rise relative to futures prices, causing the difference between the cash and futures prices to narrow. For example, if the cash price increases while the futures price remains stable, the basis strengthens.
| Cash | – Apr Corn Futures | = Basis | |
|---|---|---|---|
| Mar 1 | $4.20 | – $4.70 | = – $.50 |
| Mar 15 | $4.55 | – $4.95 | = – $.40 |
| Apr 1 | $4.50 | – $4.80 | = – $.30 |
In the example above, it’s clear that the basis can strengthen whether prices are rising or falling.
A strengthening basis benefits the short hedger, who uses futures to protect against potential price declines in a commodity they own or deal in. Essentially, a short hedger is long in the spot market and short in the futures market. We’ll explore hedging strategies in more detail in upcoming articles.
Think of basis as the temperature on a thermometer: if the temperature goes from 10 below zero to zero, it has gone up (strengthened) by 10 degrees. If the temperature goes from 30 above zero to 20, it has gone down (weakened) by 10 degrees.
Weakening Basis
A weakening basis occurs when cash market prices rise more slowly than futures prices or when cash prices decline more rapidly than futures prices. This results in a basis that becomes more negative or less positive.
A weakening basis benefits the long hedger, who uses futures to protect against potential price increases in a commodity they will need to purchase in the future. In other words, a long hedger is short in the spot market and long in the futures market.
| Cash | – Apr Corn Futures | = Basis | |
|---|---|---|---|
| Mar 1 | $4.60 | – $4.25 | = + $.35 |
| Mar 15 | $4.45 | – $4.20 | = + $.25 |
| Apr 1 | $4.55 | – $4.35 | = + $.20 |
In the example above, it’s evident that the basis can weaken regardless of whether prices are rising or falling. The figure below illustrates both strengthening and weakening basis scenarios.
In summary, the basis can increase due to a rise in the spot price, a decline in the futures price, futures increasing less than the spot price, or futures decreasing more than the spot price.
Other types of basis
While strengthening and weakening basis are crucial for understanding and utilizing basis, terms like country basis and premium basis are also important.
Country basis, or local basis, is used in grain markets to compare the local cash market price with the nearby futures price. It reflects the difference between local market prices and nearby futures prices, adjusted for transportation and handling costs to a terminal market (e.g., Chicago). This helps assess the fairness of local market prices.
Premium basis refers to a market condition where cash prices are higher than those of distant futures contracts, indicating an inverted market.
Assume that the spot price for the commodity is $100/unit. Let us further assume that the carrying charge is $4 a month, while the one-month futures contract is priced at $110. A deft arbitrageur could pocket a riskless profit of $6 per unit in this case by buying the commodity at the spot price (and storing it for a month for $4) while simultaneously selling it for delivery in a month at $110.
Carrying charge relationship
The relationship between local cash prices and futures prices is influenced by several factors, including:
- Time and interest (financing costs)
- Insurance
- Supply and demand (both domestic and international)
- Transportation
- Production costs
- Storage costs
- Future expectations
The largest component of carrying charges is financing costs. It is typically assumed that the funds required to purchase and hold the cash commodity are borrowed. Even if the money is not actually borrowed, there is an opportunity cost associated with its use. The prime rate is used to calculate these carrying charges.
Wishing you a great week!
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