Basis and Basis Trading

Basis is the difference between the spot (cash) price of an asset and the price of a related futures contract. It sounds like a technical detail, but basis is central to how futures are used. Hedgers care about basis because it determines how well their hedge works. Traders care about it because the predictable convergence of basis toward zero at expiry, and its swings along the way, create trading opportunities.

Definition#

basis = spot price - futures price

Some markets quote it the other way round (futures minus spot), especially in financial and crypto futures, so always check the convention.

• Negative basis (futures above spot) is typical of contango.
• Positive basis (futures below spot) is typical of backwardation.

See Spot vs Futures, Contango and Backwardation.

Basis for hedgers#

A farmer, refiner or fund hedging with futures is exposed to changes in basis, not just in price. If the local cash price and the futures price move by different amounts, the hedge is imperfect. This is basis risk.

What moves basis#

Basis trading#

Basis traders take offsetting positions in the cash asset and futures to profit from changes in basis rather than outright price.

• Long the basis: buy the cash asset and sell futures. Profits if the basis strengthens (cash gains relative to futures). The classic cash and carry trade is a long basis position held to expiry. See Cash-and-Carry Arbitrage.
• Short the basis: sell (or short) the cash asset and buy futures. Profits if the basis weakens.

The Treasury basis trade#

In the US Treasury market, hedge funds buy Treasury bonds and sell Treasury futures, financing the bonds through repurchase agreements (repo). They profit from the small difference between the bond and futures prices, magnified with high leverage. The trade is large; regulators including the Federal Reserve have estimated it in the hundreds of billions of dollars. In March 2020, sharp moves in Treasury and repo markets forced rapid unwinding of basis trades, contributing to market stress that the Federal Reserve addressed with large purchases of Treasuries. See Treasury Bills, Notes and Bonds.

Crypto basis#

Crypto futures and perpetual swaps often trade above spot, sometimes by large annualised margins in bull markets. Traders buy spot and short futures to capture this basis, a popular strategy in crypto. See Crypto Futures and Basis and Funding and Basis Arbitrage.

Risks of basis trading#

• Basis can move against you before converging.
• Leverage: small spreads require large positions and borrowing.
• Funding risk: financing costs (such as repo rates) can jump.
• Delivery and quality details: for bonds, the cheapest to deliver security can change.
• Counterparty and platform risk, especially in crypto.

Frequently asked questions#

What is basis in futures?#

The difference between the spot price of an asset and the price of a related futures contract.

What is basis risk?#

The risk that the spot and futures prices move by different amounts, making a hedge less effective than expected.

What is the Treasury basis trade?#

A leveraged trade in which funds buy Treasury bonds and sell Treasury futures, profiting from small price differences, financed in the repo market.

Next, learn how futures histories are stitched together in Continuous Futures and Back-Adjustment.