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.

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