What is Basis in Futures Contracts?

If you`re interested in trading futures contracts, it`s important to understand the concept of basis. Basis can be thought of as the difference between the price of a futures contract and the current spot price of the underlying asset. Essentially, it represents the cost of carrying the asset from the present day until the expiration date of the futures contract.

In a perfect market, the basis would always be zero, since the futures price would perfectly reflect the spot price. However, this is rarely the case. Basis can be positive or negative, depending on a variety of factors.

Factors Affecting Basis

One major factor affecting basis is supply and demand. If there is a shortage of an asset, the spot price will increase relative to the futures price, resulting in a negative basis. On the other hand, if there is an oversupply of the asset, the spot price will decrease relative to the futures price, resulting in a positive basis.

Another factor affecting basis is the cost of carry. This includes things like storage costs, insurance, and financing charges. If these costs are high, the basis will be negative. If they are low, the basis will be positive.

Finally, basis can be affected by market sentiment. If traders expect the spot price to increase in the future, they may be more willing to pay a premium for futures contracts, resulting in a positive basis. Conversely, if traders expect the spot price to decrease, they may demand a discount on futures contracts, resulting in a negative basis.

Why is Basis Important?

Basis is important because it can affect the profitability of futures trades. For example, if a trader buys a futures contract with a positive basis and the spot price decreases, they may still be able to sell the asset for a profit because the futures price was higher than the spot price when they bought the contract. Similarly, if a trader sells a futures contract with a negative basis and the spot price increases, they may be able to buy the asset back at a lower price than they sold it for, resulting in a profit.

Basis can also be used to analyze market trends. For example, if the basis for a particular asset is consistently negative, it may indicate that there is a shortage of that asset in the market. Conversely, a consistently positive basis may indicate an oversupply.

Conclusion

Understanding basis is an important part of trading futures contracts. Basis represents the difference between the futures price and the spot price of the underlying asset, and can be affected by factors like supply and demand, cost of carry, and market sentiment. By analyzing basis, traders can make more informed decisions about when to buy and sell futures contracts, and can also gain insight into market trends.