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

    A convertible bond arbitrage is an arbitrage strategy that aims ...
  3. Fixed-Income Arbitrage

    An investment strategy that attempts to profit from arbitrage ...
  4. Arbitrage

    Arbitrage is the purchase and sale of an asset at the same time ...
  5. Currency Arbitrage

    Currency arbitrage is the act of buying and selling currencies ...
  6. Municipal Bond Arbitrage

    Municipal bond arbitrage is building a leveraged portfolio of ...
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

    The Roles of Traders and Investors

    Discover how these two groups work together to keep the market functioning properly.
  3. Trading

    Day trading: An introduction

    This article takes an objective look at day trading, who does it, and how it is done.
  4. 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.
  5. Investing

    How Statistical Arbitrage Can Lead to Profits

    Find out how statistical arbitrage is leveraged by traders and investors seeking profit by capitalizing on the relationship between price and liquidity.
  6. 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.
  7. Trading

    The 10 Worst Mistakes Beginner Traders Make

    Traders generally buy and sell securities more frequently and hold positions for much shorter periods than investors, which can result in costly mistakes.
RELATED FAQS
  1. 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 >>
  2. What is the difference between arbitrage and hedging?

    Dive into two very important financial concepts: arbitrage and hedging. See how each of these strategies can play a role ... Read Answer >>
  3. What is the difference between arbitrage and speculation?

    Arbitrage and speculation are very different strategies. Arbitrage involves the simultaneous buying and selling of an asset ... Read Answer >>
Hot Definitions
  1. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  2. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  3. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  4. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  5. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  6. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
Trading Center