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Key Takeaways

Basis trading is about taking advantage of price gaps between what something costs now (spot price) versus what it’s expected to cost later (futures price).

Farmers, investors, and crypto traders can use basis trading strategies to hedge risks or make profits. It’s popular in commodities, bonds, and Bitcoin markets.

Basis trading involves risks and can be confusing for beginners. It requires understanding market dynamics and managing risks due to unexpected price movements or eventual liquidity issues.

What Is Basis Trading?

Imagine you’re buying apples at the grocery store for $1.50 each. But your friend is offering to sell you a batch of apples, which they will deliver next month for $1.30 each. That 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 grow, you “long the basis.” If you think it will shrink, you "go short." It’s a game of strategy, analysis, and sometimes luck.

How Basis Trading Works

Spot and futures prices

The spot price is what you’d pay right now, while the futures price is what’s agreed upon for a future date. These prices often differ because they account for multiple factors, such as storage, interest rates, or expectations about supply and demand.

For example, let’s say corn costs $5 a bushel today (spot price), and the futures price for corn three months from now is $5.50. The basis, in this case, is -$0.50. If you believe the spot price will rise faster than the futures price, you might "go long" on the basis.

Types of basis trades

Traders can go long or short, depending on their analysis. They often use a mix of market trends, historical data, and economic factors to make their predictions.

Long: Betting that the spot price will increase relative to the futures price.

Short: Betting that the spot price will fall or that the futures price will rise faster.

Why Is Basis Trading Such a Big Deal?

For hedgers

Basis trading can be a lifesaver for people who produce or rely on commodities. Think about a wheat farmer. They know they’ll harvest 10,000 bushels in three months, but they’re worried about prices dropping. By selling futures contracts now, they lock in a price and reduce their risk.

On the flip side, a bread factory might use basis trading to secure future wheat supplies at a predictable cost. Both parties are protecting themselves from unpleasant surprises.

For speculators

Speculators are in it for the profits. They study market trends and bet on where the basis is heading. For example, if a trader thinks strong demand will push up the spot price of oil, they’ll "go long" and cash in if their prediction comes true.

Where Do Traders Use Basis Trading?

1. Commodities

This is where basis trading shines. Farmers, miners, and energy producers use it to hedge risks while speculators look for profits. Basis trading can be done with grains, oil, gold, or any other commodity that has a spot and futures market.

2. Fixed income (bonds)

In bond markets, traders often look at the difference between cash bonds and derivatives like credit default swaps (CDS). A "negative basis trade" happens when the spread on CDS is smaller than the bond’s spread. This creates arbitrage opportunities for traders.

3. Cryptocurrencies

In the context of cryptocurrencies, the basis trading relies on the gap between the price of a crypto asset in the spot market and the price of their contracts in futures markets. 

Crypto basis trading became significantly more popular after the launch of spot Bitcoin ETFs in early 2024. Since then, many traders started exploring price differences between spot ETFs and major futures markets such as the CME Bitcoin Futures.

Bitcoin basis trading example

Bitcoin basis traders look for price differences between the spot market (where BTC is traded instantly) and futures contracts (which track the cryptocurrency’s future prices). 

For example, if BTC is trading at $80,000 in the spot market, but futures contracts for delivery in three months are priced at $82,000, Alice could buy bitcoin on 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 for delivery in 3 months.

Basis: $2,000.

Rationale: Alice believes this $2,000 gap (basis) will shrink over the next few weeks due to increasing spot demand or decreasing futures premium.

Strategy: Alice executes a cash-and-carry arbitrage, buying BTC in the spot market for $80,000 and selling a BTC futures contract for $82,000. 

Outcome: If the prices converge as expected, Alice uses the BTC bought in the spot market to fulfill the futures contract, effectively locking a $2,000 profit per BTC minus fees and operational costs.

Risks and Challenges of Basis Trading

1. Basis risk

One of the biggest headaches for basis traders is when the spot and futures prices don’t move as expected. For instance, a farmer hedging corn prices might lose money if unpredictable weather disrupts supply and demand.

2. Market liquidity

If the market doesn’t have enough liquidity, traders might struggle to enter or exit positions at the desired prices. This is especially true in volatile markets or during financial crises.

3. Complexity

Basis trading can be complicated at times. Understanding market dynamics, analyzing trends, and managing risks effectively requires expertise. Beginners might find themselves overwhelmed.

Closing Thoughts

Basis trading might sound complex, but at its core, it’s all about making smart bets on price differences. Whether you’re managing risks in commodities, hunting for profits in bonds, or navigating the world of crypto, this strategy offers plenty of opportunities.

If you’re an investor, understanding basis trading can open up new opportunities to protect your portfolio or boost 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 are doing.

Further Reading

What Are Carry Trades and How Do They Work?

What Are Bonds and How Do They Work?

Interest Rates Explained

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