DEFINITION of 'Basis Trading'

An arbitrage trading strategy that aims to profit from perceived mispricing of similar securities. Basis trading relates to a trading strategy in which a trader believes that two similar securities are mispriced relative to each other, and the trader will take opposing long and short positions in the two securities in order to profit from the convergence of their values. The strategy is known as basis trading, because it typically aims to profit off very small basis point changes in value between two securities.

BREAKING DOWN 'Basis Trading'

For example, a basis trader may view two similar bonds as mispriced and take a long position in the bond deemed to be undervalued, and a short position in the bond which would then be seen as overvalued. The trader's hope is that the undervalued bond will appreciate relative to the overpriced bond, thus netting him a profit from his positions. For the trader to make a worthwhile profit, he would have to undertake a large amount of leverage in order to increase the size of his positions. This use of large degrees of leverage is the greatest risk involved in basis trading.

RELATED TERMS
  1. Set-Up Hedge

    An arbitrage strategy involving a long position in a convertible ...
  2. Convertible Bond Arbitrage

    An arbitrage strategy that aims to capitalize on mispricing between ...
  3. Chinese Hedge

    A position that protects investors from risk, involving a short ...
  4. Fixed-Income Arbitrage

    An investment strategy that attempts to profit from arbitrage ...
  5. Arbitrage Trading Program - ATP

    A computer program used to place simultaneous orders for stock ...
  6. Currency Carry Trade

    A strategy in which an investor sells a certain currency with ...
Related Articles
  1. Investing

    How ETF Arbitrage Works

    ETF arbitrage brings the market price of ETFs back in line with net asset values when divergence happens. But how does ETF arbitrage work?
  2. Investing

    What Type Of Trader Are You?

    There are different ways stock traders attempt to profit from market movements. Which of the strategies do you use?
  3. Trading

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  4. Trading

    How Much Trading Capital Do Forex Traders Need?

    Even a small pip profit can mean substantial percentage returns over time.
  5. Investing

    Arbitrage Squeezes Profit From Market Inefficiency

    This influential strategy capitalizes on the relationship between price and liquidity.
  6. Personal Finance

    A Day in the Life of a Day Trader

    Day trading has many advantages and, while we often hear about these perks, it's important to realize that day trading is hard work.
  7. Investing

    How To Arbitrage Precious Metals

    Here are the fine points, trading tips, suitable securities, and examples for precious metal arbitrage trading.
  8. Trading

    4 Common Active Trading Strategies

    Learn four of the most popular active trading strategies and why active trading isn't limited to professional traders anymore.
  9. Trading

    Make Money Through Risk Arbitrage Trading

    Risk arbitrage provides a valuable trading strategy for M&A or other corporate actions eligible stocks. Investopedia explains how it works.
RELATED FAQS
  1. How do I employ a cash-and-carry trade?

    The cash-and-carry trade is an arbitrage strategy of purchasing one security while simultaneously selling a similar security. ... Read Answer >>
  2. What is arbitrage pricing theory?

    Find out what arbitrage pricing theory is and how it can theoretically be used by investors to generate risk-free profit ... Read Answer >>
  3. How do I use the news to find arbitrage opportunities?

    Learn what risk arbitrage trading is and how this type of arbitrage trading opportunity is available to individual retail ... Read Answer >>
  4. How do I use software to make arbitrage trades?

    Understand the meaning of arbitrage trading, and learn how traders employ software programs to detect arbitrage trade opportunities. Read Answer >>
Hot Definitions
  1. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  2. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  3. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  4. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  5. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  6. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
Trading Center