Hedging - The Basis

The Basis
The basis tends to be more stable than either the cash or futures price. It also tends to differ from one exchange to another. Among conditions factoring into the basis are:

  • Current supply and demand locally,
  • Market expectations of changes in supply and demand,
  • Availability of substitutes,
  • Interest,
  • Handling costs (that is, middlemen's profit margins),
  • Storage availability and its associated costs, and
  • Transportation bottlenecks or disruptions.

The basis varies seasonally, but these swing fairly predictable year-over-year patterns.

Determining the basis
The basis is determined by subtracting the futures price from cash price, but that raises the question, "Which futures price?" The general rule is to not use a contract's price during its delivery month. In a perfect market, as we described, the basis would always be at or approaching zero, if the basis were figured that way. A calculation that compares prices for September cash corn with September futures corn in September won't really measure anything except distortions from logistical hiccups. The transaction would be for naught. Instead, the basis would be calculated in September by subtracting the December futures price (there is no market for October or November corn) from the September cash price.

The basis tends to be negative for most agricultural commodities, or "under" the futures price, due to the cost of carry. Conversely, a positive basis is said to be "over" the future price. If the basis is more negative or less positive than usual, it is considered "weaker" than the historical norm. If it is less negative or more positive, then, it is said to be "stronger."

Say that September cash corn is trading at 228 cents/bushel and December futures corn is trading at 248 cents/bushel. In market parlance: "The basis is 20 under December."

The basis indicates current local demand. A strong basis means the market wants the grain sooner rather than later. A weak basis suggests that the market doesn't want grain now, although demand may grow over a matter of months.

Strong basis trends toward a less negative and more positive number. Cash prices increase relative to futures prices. This works to the seller's benefit. He or she would sell at the cash price, benefitting from the aforementioned increased local demand.

Weak basis trends toward a less positive and more negative number. Cash prices decrease relative to futures prices. This works to the buyer's benefit. He or she would enter into a futures contract, benefitting from anticipated future demand.

LOOK OUT!
The basis is a localized phenomenon. It could be under and weakening in a Midwestern farm community, but over and strengthening in Chicago or New York.

All this helps the producers of the commodities – those likely to be short-the-basis, to decide how to sell. As the basis strengthens, the producer's incentive is to sell for cash. As the basis weakens, the producer's incentive is to enter into a futures contract.


How Hedgers Utilize Basis


Related Articles
  1. Fundamental Analysis

    A Common Base for Understanding Changes in Value

    A discussion of basis points as well as basis point calculations using Excel.
  2. Investing Basics

    Know Your Stock Cost Basis

    Understanding equity cost basis is critical for tracking the gains or losses of an investment.
  3. Active Trading

    Investing Seasonally In The Corn Market

    Each month can bring new growth opportunities, if you know where the right investment seeds are.
  4. Active Trading

    Grow Your Finances In The Grain Markets

    Hedging with futures can protect those who buy and sell commodities from adverse price movements.
  5. Active Trading Fundamentals

    Get Positive Results With Negative Basis Trades

    Capitalize on the difference in spreads between markets with this popular strategy.
  6. Investing Basics

    What Determines Your Cost Basis?

    In any transaction between a buyer and seller, the initial price paid in an exchange for a product or service will qualify as the cost basis. When it comes to securities and related financial ...
  7. Chart Advisor

    Corn's Bullish Base Could Yield 2016 Breakout (CORN)

    Corn is building an inverse head and shoulders base that could support a rally above 500.
  8. Options & Futures

    Analyzing The 5 Most Liquid Commodity Futures (WTI, ZC)

    Crude oil leads the pack as the most liquid commodity futures market, followed by corn and natural gas.
  9. Options & Futures

    Advantages Of Trading Futures Over Stocks (APPL)

    We look at the top eight advantages of trading futures over stocks.
  10. Investing Basics

    Cost Basis Basics

    The term "cost basis" refers to the original value of a security you own. When you sell a stock, bond or mutual fund, you use the cost basis to determine your profit or loss, which in turn affects ...
RELATED TERMS
  1. Booking the Basis

    An arrangement made between a buyer and seller giving either ...
  2. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote ...
  3. Wide Basis

    A condition found in futures markets in which the spot price ...
  4. Cost Basis

    1. The original value of an asset for tax purposes (usually the ...
  5. Narrow Basis

    A condition found in futures markets in which the spot price ...
  6. Basis

    1. The variation between the spot price of a deliverable commodity ...
RELATED FAQS
  1. Why are bond yields calculated in terms of basis points?

    Find out why financial analysts and publications track and quote bond yields in basis points, or bps, rather than simply ... Read Answer >>
  2. How do I figure out my cost basis on a stock investment?

    The cost basis of any investment is the original value of an asset adjusted for stock splits, dividends and capital distributions. ... Read Answer >>
  3. What is an adjusted cost basis and how is it calculated?

    Learn what adjusted cost basis is, how it is calculated, and why this metric is important for investors, business owners ... Read Answer >>
  4. What is a basis point (BPS)?

    A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial ... Read Answer >>
  5. What types of items can you buy futures for?

    Learn what items futures may be purchased for, what a futures contract is and discover how the futures markets have greatly ... Read Answer >>
  6. Why do futures' prices converge upon spot prices during the delivery month?

    It's a fairly safe bet that as the delivery month of a futures contract approaches, the future's price will generally inch ... Read Answer >>
Hot Definitions
  1. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  2. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  3. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  4. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  5. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  6. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
Trading Center