What is Basis Trading
Basis trading is an arbitrage trading strategy that seeks to profit from perceived mispricing of securities. If a trader believes that two similar securities are mispriced relative to each other, they will take opposing long and short positions in the two securities in order to profit from the convergence of their values.
This strategy is called basis trading because it typically aims to profit from small basis point changes in value between two securities.
BREAKING DOWN Basis Trading
With basis trading, for example, a trader who sees two similar bonds as mispriced would opt to take a long position in the bond thought 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. In order make a worthwhile profit, they would have to undertake a large amount of leverage in order to increase the size of their positions. This use of large degrees of leverage is the greatest risk involved in basis trading.
Basis trading is common across futures commodities markets, "where derivative products are readily traded against each other as well as in conjunction with their underlying assets," as one futures trading site, Daniels Trading, explains. "In addition to commodities, basis trades typically involve contracts based upon debt instruments, currencies or equities indices."
Basis Trading in Practice
One area where basic trading is popular is the grain trade. As Hank King notes in this Investopedia blog post, "because grain is a tangible commodity, the grain market has a number of unique qualities. First, when compared to other complexes like the energies, grains have a lower margin making it easy for speculators to participate. Also, grains generally aren't one of the bigger contracts (in terms of total dollar amount), which accounts for the lower margins.
The fundamentals in the grains are fairly straightforward: like most tangible commodities, supply and demand will determine the price. Weather factors will also have an effect."
Daniels Trading explains that basis trading strategy is used by grain elevators and, sometimes farmer, who are "looking to take advantage of favorable basis prices by exploiting the difference between the cash and futures. Grain elevators buy and sell grain all year around. When elevators make commitments to buy corn from farmers on the local market, elevators will also sell futures close to the cash delivery date to hedge themselves. When elevators make commitments to sell corn to ethanol plants and other end uses, they will also buy futures with expirations close to the cash delivery date to hedge themselves."