What is Basis in Derivative?

The concept of basis in derivatives is crucial for traders and portfolio managers to understand. It is the value difference between the current price of a commodity and its future contract. The relationship between cash and futures prices influences the value of contracts used for hedging. 

However, the gaps between the spot price and the futures price until the expiration of the nearest contract are not uncommon. This is what often makes the basis in derivatives imprecise.

As a result, the basis may not accurately reflect the true difference in prices. Other factors that can affect the basis include variations in actual product quality, delivery locations, and other market conditions. 

Despite its potential inaccuracies, investors use their understanding of what is basis in derivatives to estimate the value of the contract relative to the underlying commodity. Delve deeper into this article to understand more about the concept of basis. 

Implementing basis trading in the derivatives market

Basis trading is common in markets where financial instruments or commodities can be easily traded against each other. The trade basis in financial derivatives involves buying an asset they believe is undervalued and simultaneously selling another asset they believe is overvalued. 

To maximise profits, traders often use leverage when taking both long and short positions. However, this strategy carries significant risk because the returns can be highly volatile. 

Basis trading strategies

The different techniques for basis in derivatives include taking advantage of the difference in price between the current and the future market. Traders seek to make money from the merging of this gap as it decreases. It usually happens by buying the core asset and hedging with a futures contract.

A popular technique is known as the Cash and Carry strategy, in which investors purchase the actual product and at the same time sell futures. This tactic works well in markets with favourable carry prospects. Here, the futures contract is valued more than the current price. So investors can secure a guaranteed profit. 

Another commonly used approach is the Reverse Cash and Carry. It is deployed when the futures cost is lower than the current price, signalling a negative basis. In this scenario, investors sell the product in the current market and obtain the related futures. It helps in speculating that the basis will narrow or become less negative.

Finding the basis of a derivative

Using the example of a farmer selling wheat, let’s explore how to find a basis in derivatives.

Imagine a farmer expecting to deliver his wheat in three months. Concerned about potential price drops, he makes several futures contracts to sell his entire production. 

When the current spot price for wheat is र 2000 per quintal, the farmer notices a futures contract for the same quantity that expired two months ago had a price of र 2500. This indicates that the farmer can secure a price of र 2000 + र 500 (basis) for his future sale. 

The concept of leverage in basis trading

Leverage involves using borrowed funds to amplify your investment’s potential earnings. It can increase profits but also amplify potential losses. Traders use leverage when they expect a profitable return on their investment.

But leverage also comes with unlimited downside risk when used to take short positions. It happens because an asset’s price can theoretically rise indefinitely.

Understanding basis risk

Basis risk, a crucial concern for traders and hedgers, arises when the spot and futures prices of an underlying asset fail to converge on the trade’s settlement date. This divergence, caused by imperfect hedging strategies, creates a market risk. The difference between the cash price of the hedged asset and the price of the corresponding hedged futures contract represents the numerical value of basis risk in derivatives, which can be positive or negative.

Types of basis risk

The different categories of basis risk in derivatives are as follows:

• Price basis risk

A discrepancy arises when the current market price and the expected future price of a commodity diverge or fail to follow a consistent pattern throughout a trade. For instance, fluctuating gold spot price and stable future value creates a disconnect between the two rates.

• Location basis risk

In the world of trading goods, it is typical for the futures market for hedging to be located in a different place from the spot market, where real transactions happen. This may result in differences between futures prices used for hedging and spot prices for the actual asset. For example, the future cost of crude oil in Delhi might not match the spot cost in Singapore.

• Calendar basis risk

During actual market deals, the date of selling can be different from the end date of agreements for future trades on the stock market. For example, when dealing with HDFC Bank stocks, the date of selling comes before the end date for future agreements on the National Stock Exchange by a span of 15 days.

• Product quality basis risk

It occurs when the characteristics or attributes of the financial instrument used for hedging differ from those of the asset being hedged. For instance, crude oil futures may be employed to manage risks associated with the spot price of ATF.

Benefits of basis trading

Some benefits of basis in financial derivatives are as follows:

• Better hedging

Basis trading enables traders to lock in the difference between the present market value and a future contract price. By doing so, traders can effectively hedge against price fluctuations. This hedging strategy helps traders secure more stable financial outcomes in the face of market volatility.

• Profit potential

Basis trading allows traders to profit from the trend of the price difference between spot and futures markets approaching zero. By forecasting changes in this price gap, traders can engage in buying or selling contracts.

• Market insights

Trading basis in financial derivatives markets enhances traders’ understanding of market behaviours. They gain the ability to predict future price fluctuations based on current basis levels. Using this knowledge, traders can adapt their strategies to capitalise on market trends, resulting in enhanced decision-making and a more advantageous market position.

• Versatile approach

This trading strategy is flexible and can be used with different commodities and financial instruments. This allows for diversification and helps manage risk, increasing the potential for successful trades.

• Minimal barriers

Basis trading often demands less initial investment than other trading approaches. This convenience allows beginners to enter the market and trade with a lower financial burden. This accessibility can increase the number of participants, fostering a more competitive market.

Ending Note

Trading derivatives requires extensive expertise and tolerance for risk. Understanding the basis in derivatives is essential for investors planning to engage in this complex asset class. This knowledge enables them to grasp the impact of derivatives on market prices and maximise their profit potential.

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