What is a Narrow Basis
A narrow basis refers to the convergence of the spot price and the futures contract commodity price and implies an efficient and liquid market. A narrow basis is a relatively small spread in price between the commodity spot price and a short-term futures contract.
BREAKING DOWN Narrow Basis
Basis carries several different meanings in the investing world. Used in the futures market, basis refers to the spread between the delivery price detailed on a futures contract and the spot price of a given commodity. Basis can be determined by the following formula:
- Basis = futures contract price - spot delivery price
A futures contract binds a buyer and seller to an agreement to exchange a specific quantity and grade of a commodity. The exchange is at an agreed-upon price and delivery is set at a particular future time. In an efficient market, where supply perfectly satisfies demand and is expected to do so in the future, the spot price for a commodity should steadily approach the cost of the futures contract. The two prices should converge, and be equal at the expiration date of the agreement. Under these conditions, the value of the future to both buyer and seller shrinks to zero. In other words, the buyer of the futures is not paying a lesser price for the commodity traded than they would have to spend on the open market on that day. Likewise, the seller of the commodity is not gaining more profit then if they sold on the open market.
In the imperfect world, the basis is affected by factors beyond the control of futures market participants. Transportation, holding, and interest costs can all add to the expenses of the product itself. Unforeseen weather conditions present a persistent threat to the stability of any market. For agricultural products, proximity to harvest may also have a significant effect on futures trading. Under these uncertain conditions, there is no guarantee of a narrowing basis, and arbitrage opportunities may exist for a trader of futures contracts. Arbitrage is the simultaneous purchase and sale of an asset to profit from an imbalance in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in various forms.
Example of a Narrowing Basis
A bushel of soybeans is trading in the January 2018 spot market for $1. January 2019 soybean contracts are available for $1.25. The futures price suggests that traders expect soy prices to rise slightly over the year. This increase could be due to an anticipated rise in demand relative to supply, an anticipated drought, or any other reason. If these conditions occur as expected, the spot price should approach the $1.25 per bushel futures price as 2018 progresses. This closing of the gap between prices is a narrowing basis.
When basis narrows from below, moving from $0.25 to $0.10 difference, for example, it is strengthening. This strength is advantageous to a trader holding a long hedge position. A weakening basis is a high-to-low movement and is preferable to the short hedge holder, typically the producer of a commodity guarding against a decline in price.