Basis Trading

AAA

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.

INVESTOPEDIA EXPLAINS '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. Bond

    A debt investment in which an investor loans money to an entity ...
  2. Basis Point (BPS)

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

    1. Borrowed money that is used to purchase securities. This practice ...
  4. Short (or Short Position)

    1. The sale of a borrowed security, commodity or currency with ...
  5. Arbitrage

    The simultaneous purchase and sale of an asset in order to profit ...
  6. Sharpe Ratio

    A ratio developed by Nobel laureate William F. Sharpe to measure ...
Related Articles
  1. Options & Futures

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  2. Options & Futures

    Put-Call Parity And Arbitrage Opportunity

    Look at trades that are profitable when the value of corresponding puts and calls diverge.
  3. Active Trading Fundamentals

    An Introduction To Behavioral Finance

    Curious about how emotions and biases affect the market? Find some useful insight here.
  4. Options & Futures

    Bond Spreads: A Leading Indicator For Forex

    Here we examine some telling patterns in the relation between countries' interest rates and their currency pairs.
  5. Options & Futures

    Hedge Funds Hunt For Upside, Regardless Of The Market

    Hedge funds seek positive absolute returns, and engage in aggressive strategies to make this happen.
  6. Investing

    Why Is Arbitrage Trading Legal?

    Not only is arbitrage legal in the US and most developed countries, it can be beneficial to the overall health of a market.
  7. Mutual Funds & ETFs

    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?
  8. Trading Strategies

    The Top Five Stocks For Novice Swing Traders

    New to Swing Trading? Here are the top five stocks recommended for swing trading.
  9. Options & Futures

    Advantages Of Trading Futures Over Stocks

    We look at the top eight advantages of trading futures over stocks.
  10. Options & Futures

    The Basics Of Trading S&P 500 Price Progression

    The S&P 500 index futures contract works exceptionally well as a road map for short-term market timing and direction.

You May Also Like

Hot Definitions
  1. Price-To-Sales Ratio - PSR

    A valuation ratio that compares a company’s stock price to its revenues. The price-to-sales ratio is an indicator of the ...
  2. Hurdle Rate

    The minimum rate of return on a project or investment required by a manager or investor. In order to compensate for risk, ...
  3. Market Value

    The price an asset would fetch in the marketplace. Market value is also commonly used to refer to the market capitalization ...
  4. Preference Shares

    Company stock with dividends that are paid to shareholders before common stock dividends are paid out. In the event of a ...
  5. Accrued Interest

    1. A term used to describe an accrual accounting method when interest that is either payable or receivable has been recognized, ...
  6. Absorption Costing

    A managerial accounting cost method of expensing all costs associated with manufacturing a particular product. Absorption ...
Trading Center