The key to using commodity futures effectively is basis. Basis is used to ascertain the best time to buy or sell, when to hedge, or the futures month in which to place a hedge and more.
What Is Basis?
Basis is the price difference between the local cash price of a commodity and the price of the specific futures contract at any given time. Although basis compares two prices that usually move in the same direction, the two prices do not often 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 because of certain costs, such as the cost of carrying or storing physical commodities. Keep in mind that carrying charges only apply to commodities that are storable and deliverable, such as wheat, corn, cotton, coffee, gold, and copper.
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Commodities that are not storable and don’t have carrying charges include live hogs and live or feeder cattle. Other commodities, such as sugar or foreign currencies, do not fall neatly into a specific category and must be investigated individually, and are not testable. In normal market conditions, cash prices on actuals are lower than nearby futures prices.
With the approach of delivery on the futures, the price difference between cash and futures often decreases, or converges.
Graphical Representation of Negative Basis in a Normal Market
The largest portion of the carrying charges is the financing costs. It is always assumed that the money necessary to buy and hold the cash commodity is borrowed. Even if the money is not borrowed, there is a cost to use it, as the user loses the opportunity to use the money in other investments. The borrowing cost used when calculating carrying charges is the prime rate.
What is convergence?
The space between the futures and cash lines is the basis. Basis converges to zero over time.
Take a note! A negative basis is also referred to as “cash under futures,” which points to cash prices that are below the futures. A positive basis is referred to by many as “cash over futures.”
Strengthening Basis
A strengthening basis occurs when the cash market prices increase relative to the futures prices. In other words, the difference between cash and futures prices narrows, as seen in the following example.
| 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, we can see that the basis can strengthen regardless of prices moving higher or lower.
A strengthening basis benefits the short hedger (a selling hedge). A short hedger is someone who owns or deals in a commodity and hedges (protects) its future sale price by selling futures. In other words, s short hedger is long the spot and short the futures. We will discuss hedging further in the next 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 either cash market prices increase more slowly than futures prices or cash prices decrease more quickly than the futures prices. In other words, the basis becomes more negative or less positive.
A weakening basis benefits a long hedger (a buying hedge). A long hedger is someone who will need to buy a commodity in the future and hedges (protects) its future cost by buying futures. In other words, a long hedge is short the spot and long the futures.
| 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 we can see that basis can weaken regardless of prices moving higher or lower. The figure below illustrates a strengthening and weakening basis.
In summary, basis can increase due to an increase in spot price and/or a decrease in the futures price, or futures increasing less than the spot, or futures decreasing more than spot.
Other types of basis
Although strengthening basis and weakening basis are the key elements in understanding and using basis, country basis, and premium basis are also frequently used terms.
Country basis, or local basis, is used in the grain markets. It refers to the local cash market price compared with the nearby futures price (nearby month). Compared with nearby futures, after adjustments for transportation and handling costs from the local markets to a terminal market (e.g., Chicago), local market prices can be tested for fairness.
Premium basis refers to an inverted market in which the cash prices are higher than distant futures contracts.
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 are affected by many factors, including:
- Time, interest (financing cost);
- Insurance;
- Supply and demand (domestic and foreign);
- Transportation;
- Production cost;
- Storage cost;
- Expectation about the future.
The largest portion of the carrying charges is the financing costs. It is always assumed that the money necessary to buy and hold the cash commodity is borrowed. Even if the money is not borrowed, there is a cost to use it. The borrowing cost used when calculating carrying charges is the prime rate.
Wishing you a great week!
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