basic ideas
Basis trading is about taking advantage of price gaps between what something costs now (the spot price) versus what it will cost later (the futures price).
Farmers, investors, and cryptocurrency traders can use basis trading strategies to hedge risk or make profits. It is popular in commodity, bond, and Bitcoin markets.
Trading on the basis involves risks and can be confusing for beginners. It requires understanding market dynamics and managing the risks arising from unexpected price movements or potential liquidity issues.
What is basis trading?
Imagine you buy apples at the grocery store for $1.50 each. But your friend offers to sell you a bunch of apples that he will deliver to you next month for $1.30 each. This 20-cent difference is what traders call the basis. In financial markets, the basis is the difference between the spot price and the futures price.
In basis trading, investors try to make money by predicting how this gap (the basis) will change over time. If you think the gap will widen, you “buy the basis.” If you think it will narrow, you “sell the basis.” It’s just a game of strategy, analysis, and sometimes luck.
How to do basic trading
Spot and Futures Prices
The spot price is what you will pay now, while the futures price is what is agreed upon for a future date. These prices often vary because they take into account multiple factors, such as storage, interest rates, or expectations about supply and demand.
For example, suppose a bushel of corn is worth $5 today (the spot price), and the corn futures price three months from now is $5.50. The basis in this case is -$0.50. If you think the spot price will rise faster than the futures price, you can "buy" on this basis.
Types of trading on the basis
Traders can buy or sell, depending on their analysis. They often use a combination of market trends, historical data, and economic factors to make their predictions.
Buy: Betting that the spot price will rise relative to the futures price.
Sell: A bet that the spot price will fall or that the futures price will rise faster.
Why is basis trading important?
For hedgers
Futures trading can be a lifesaver for people who produce or depend on commodities. Imagine a wheat farmer. He knows he will harvest 10,000 bushels in three months, but he is worried about the price falling. By selling futures now, he locks in the price and reduces his risk.
On the other hand, a bread manufacturer might use the basis trading to secure future wheat supplies at a predictable cost. Both parties protect themselves from unpleasant surprises.
For speculators
Speculators trade on the basis to make a profit. They study market trends and bet on the direction of the basis. For example, if a trader believes that strong demand will push up the spot price of oil, he will “buy” and make a profit if his prediction comes true.
Where do traders use basis trading?
1. Goods
This is where basis trading is best used. Farmers, miners, and energy producers use it to hedge their risk while speculators look for profits. Basis trading can be done on grains, oil, gold, or any other commodity that has both a spot and a futures market.
2. Fixed income (bonds)
In bond markets, traders often look at the spread between cash bonds and derivatives such as credit default swaps (CDS). A “negative spread” occurs when the CDS spread is lower than the bond spread. This creates arbitrage opportunities for traders.
3. Cryptocurrencies
In the context of cryptocurrencies, basis trading is based on the gap between the price of a digital asset in the spot market and the price of its contracts in the futures markets.
Trading on the underlying cryptocurrency has become significantly more popular after the launch of spot Bitcoin ETFs in early 2024. Since then, many traders have begun exploring the price differences between spot ETFs and major futures markets such as CME Bitcoin futures.
Example of trading on the basis of Bitcoin
Bitcoin spot traders look for price differences between the spot market (where BTC is traded immediately) and the futures market (which tracks the cryptocurrency's futures prices).
For example, if BTC is trading at $80,000 in the spot market, but the futures contract expiring in three months is trading at $82,000, Alice can buy Bitcoin in the spot market while selling the same amount of BTC in the futures market.
Spot price: $80,000 per BTC.
Futures price: $82,000 per BTC due in 3 months.
Base: $2,000.
Rationale: Alice believes that the $2,000 gap (the basis) will narrow over the next few weeks due to increased spot demand or a lower futures premium.
Strategy: Alice executes a forward arbitrage, buying BTC on the spot market for $80,000 and selling a BTC futures contract for $82,000.
Outcome: If prices converge as expected, Alice will use the BTC she purchased on the spot market to fulfill the futures contract, effectively guaranteeing a profit of $2,000 per BTC minus fees and operating costs.
Risks and Challenges of Trading on Basis
1. Risks of trading on the basis
One of the biggest problems for basis traders is when spot and futures prices don’t move as expected. For example, a farmer who hedges corn prices could lose money if unpredictable weather disrupts supply and demand.
2. Market liquidity
If the market does not have enough liquidity, traders may have difficulty entering or exiting trades at the desired prices. This is especially true in volatile markets or during financial crises.
3. Complexity
Trading on the basis can sometimes be complex. Understanding market dynamics, analyzing trends, and managing risk effectively requires experience. Beginners may find themselves confused.
Closing thoughts
Trading on the basis may seem complicated, but at its core it’s about making smart bets on price differences. Whether you’re managing risk in commodities, looking to make profits in bonds, or navigating the world of cryptocurrencies, this strategy offers plenty of opportunities.
If you’re an investor, understanding basis trading can open up new opportunities to protect your portfolio or increase your profits. For producers and manufacturers, it’s a way to ensure stability in unpredictable markets. And if you’re a speculator, basis trading can be an interesting (and profitable) strategy—as long as you know what you’re doing.