Basis trading is a financial trading strategy which consists of the purchase of a particular financial instrument or commodity and the sale of its related derivative (for example the purchase of a particular bond and the sale of a related
futures contract
In finance, a futures contract (sometimes called a futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset ...
).
Basis trading is done when the investor feels that the two instruments are mispriced relative to one other and that the mispricing will correct itself so that the gain on one side of the
trade
Trade involves the transfer of goods and services from one person or entity to another, often in exchange for money. Economists refer to a system or network that allows trade as a market.
An early form of trade, barter, saw the direct excha ...
will more than cancel out the loss on the other side of the trade. In the case of such a trade taking place on a security and its related futures contract, the trade will be profitable if the purchase price plus the net cost of carry is less than the futures price.
Basis of futures
Basis can be defined as the difference between the spot price of a given
cash market
The spot market or cash market is a public financial market in which financial instruments or commodities are traded for immediate delivery. It contrasts with a futures market, in which delivery is due at a later date. In a spot market, settle ...
asset and the price of its related futures contract.
[Hull, "Options, Futures and Other Derivatives", 6 Ed, Prentice Hall] There will be a different basis for each
delivery month For futures contracts specifying physical delivery, the delivery month is the month in which the seller must deliver, and the buyer must accept and pay for, the underlying. For contracts specifying cash settlement, the delivery month is the month o ...
for each contract. Usually, basis is defined as cash price minus futures price, however, the alternative definition, future price minus cash, is also used. A basis trade profits from the closing of an unwarranted gap between the futures contract and the associated cash market instrument.
See also
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Basis swap A basis swap is an interest rate swap which involves the exchange of two floating rate financial instruments. A basis swap functions as a floating-floating interest rate swap under which the floating rate payments are referenced to different bases. ...
References
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Derivatives (finance)