What Is a Basis Quote?
When discussing most futures contracts, basis refers to the futures price of a contract minus the spot price of that contract's underlying asset. However, when discussing commodity futures contracts, it has the opposite meaning, referring to the spot price of the commodity minus that commodity's futures price.
- A basis quote is a way of referring to the price of a futures contract by comparing it to the price of its underlying asset.
- The basis of most futures contracts is the price of the contract minus the spot price of that contract's underlying asset.
- For commodity futures, the basis is the spot price of the commodity minus that commodity's futures price.
- The reversal is due to commodity futures tending to be more expensive than their spot prices, largely due to the holding costs of those commodities.
- Different markets will show different patterns in terms of the relationship between spot prices and futures prices, taking into variables such as dividend payments.
How a Basis Quote Works
Futures are a type of financial asset known as a derivative whose value is linked to an underlying asset. The underlying asset can be a commodity or a financial instrument. Buyers and sellers of futures contracts use them to hedge price risk or to trade speculatively.
The intention behind a basis quote is to make it easy to understand whether a given futures contract is expensive or inexpensive when compared to its underlying asset.
In theory, you might expect futures prices to exactly match spot prices since they both refer to the same underlying asset. In practice, the two figures are rarely perfectly aligned. Traders, therefore, find it useful to quote prices in terms of the spread, or difference, between these two prices.
Trading With a Basis Quote
Different markets will show different patterns in terms of the relationship between spot prices and futures prices. In the case of equity index futures, for example, it is generally the case that the futures contracts will be priced below the spot prices because the futures do not benefit from the dividend payments made by the companies in the index.
For commodity futures, on the other hand, the futures price is generally higher than the spot price, in part because of the additional storage, insurance, carrying costs, and other costs associated with physically holding commodities.
Sometimes, these patterns will change for reasons that are unclear. When this happens, traders may take advantage of arbitrage profits by buying at a cheaper price and then immediately selling at a higher price. As traders seize on this opportunity, their arbitrage trades help to restore equilibrium in the market, lowering the amount of basis overall.
Given these various factors, it is often easiest to simply use basis quotes when referring to the price of a given futures contract in order to quickly tell whether the price of the underlying asset is above or below its futures price.
Example of a Basis Quote
To illustrate, consider the case of an equity index future priced at $100. If the index that serves as its underlying asset is at $105, then the basis quote for that equity index futures contract would be $100 – $105 = –$5.
In this scenario, the futures contract is cheaper than its underlying asset, creating a negative basis quote. This dynamic would be fairly typical for equity index futures because futures contracts do not benefit from the dividend payments made to those who directly own shares in the companies that make up the index.
In the case of commodity futures, basis quotes are given by taking the spot price for the commodity and subtracting its futures price. For example, if the spot price for a bushel of corn is $3 in January and the price of a February delivery futures contract is $3.25, then the basis quote would be $3 – $3.25 = –$0.25. Here, it makes sense that the futures contract would be more expensive than the spot price, in part because of the added costs associated with physically holding the commodity.