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.

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. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  2. Investing

    Have Commodities Bottomed?

    Commodity prices have been heading lower for more than four years, being the worst performing asset class of 2015 with more losses in cyclical commodities.
  3. Investing

    Oil: Why Not to Put Faith in Forecasts

    West Texas Intermediate oil futures have recently made pronounced movements. What do they bode for the world market?
  4. Investing

    The Quinoa Quandary for Bolivian Farmers

    Growing global demand for quinoa has impacted Bolivian farmers' way of life. Should the American consumer be wary of buying this product?
  5. Economics

    Is the U.S. Economy Ready for Liftoff?

    The Fed continues to delay normalizing rates, citing inflation concerns and “global economic and financial developments” in explaining its rationale.
  6. Investing News

    What Alcoa’s (AA) Breakup Means for Investors

    Alcoa plans to split into two companies. Is this a bullish catalyst for investors?
  7. Investing

    A Look at 6 Leading Female Value Investors

    In an industry still largely predominated by men, we look at 6 leading female value investors working today.
  8. Forex Fundamentals

    What Are the Best Hours to Trade the Mexican Peso?

    The best times to trade the Mexican peso are centered around economic releases, typically in the morning hours.
  9. Chart Advisor

    Trade Base Metals With These 3 ETFs

    News out of Alcoa is causing active traders to turn toward base metals for opportunities. Before diving into the market, check out the charts of these three ETFs.
  10. Stock Analysis

    This Is What Carl Icahn's Portfolio Looks Like

    Read about some of the holdings in Carl Icahn's portfolio. Learn about his activist campaigns against companies that he believes are performing poorly.
  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  3. Derivative

    A security with a price that is dependent upon or derived from ...
  4. Series 6

    A securities license entitling the holder to register as a limited ...
  5. Inverse Transaction

    A transaction that can cancel out a forward contract that has ...
  6. Best To Deliver

    The security that is delivered by the short position holder in ...
  1. Is a financial advisor required to have a degree?

    Financial advisors are not required to have university degrees. However, they are required to pass certain exams administered ... Read Full Answer >>
  2. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  3. Can I use my IRA to pay for my college loans?

    If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
  4. Can I use my 401(k) to pay for my college loans?

    If you are over 59.5, or separate from your plan-sponsoring employer after age 55, you are free to use your 401(k) to pay ... Read Full Answer >>
  5. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  6. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>
Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!