What Is a Narrow Basis?
The term narrow basis refers to how close the cash price of a commodity is to its future price in the commodities futures market. Put simply, there is a small difference or spread between the spot price of a commodity and its price in a futures contract. This condition generally occurs when there is a large and liquid market for a specific commodity. In this sense, it is associated with stable market conditions. A narrow basis is the opposite of a wide basis.
- A narrow basis is a market condition in which the gap between local cash prices and futures prices is relatively small.
- Such a convergence between the spot price and futures price is associated with highly liquid and stable market conditions.
- A number of costs and expenses can cause a divergence in prices, including transportation and insurance.
- An experienced trader can take advantage of market conditions to realize arbitrage profits using a narrow basis.
- The opposite of a narrow basis is a wide basis, which may indicate inefficiencies and also create arbitrage opportunities for traders.
Understanding a Narrow Basis
Commodities futures markets are a large and important part of the modern financial system. They allow commodity producers and consumers to benefit from efficient price discovery, forward hedging, reduction of counterparty risk, and other advantages. These markets also allow investors to speculate on commodity prices, which adds additional liquidity to the marketplace.
One closely-watched metric is the basis of a given commodity. It is calculated by taking the local cash price of that commodity and subtracting its most up-to-date futures price. In general, the basis for a commodity futures contract is therefore simply its local cash or the spot price (of the underlying asset) minus its futures contract price.
You may think that these two prices would be the same but that's not always the case. In fact, there is usually at least a small difference between them. A relatively small convergence between these two prices means that the commodity has a narrow basis. So why the difference? Local cash and futures prices differ because of the costs associated with taking physical delivery of a commodity, including:
- Transportation costs
- Quality control
Commodity futures contracts trade on various commodities futures exchanges, including the Chicago Board of Trade and the Chicago Mercantile Exchange, which are owned by CME Group.
You'd expect spot prices and futures prices to be equal. And this is usually true during perfect market conditions. That's because there are no additional factors at play. When this happens, buyers don't pay more and sellers don't make more money than what they would have on the open market. But perfect market conditions aren't all that common, if at all.
There are certain market conditions beyond the control of investors that can cause a divergence between a commodity's spot price and its futures price. Local conditions could have a short-term effect on commodity prices, which means there isn't a guarantee that a narrow basis will occur. And when there are imperfect market conditions, a narrow basis probably won't happen.
Astute traders can take advantage of these conditions to realize arbitrage profits. This means buying from the low-priced market and selling to the high-priced market. This arbitrage activity would in turn help restore balance to the price, leading toward a narrow basis.
Narrow Basis vs. Wide Basis
The opposite of a narrow basis in the commodities futures markets is what's known as a wide basis. This situation arises if investors expect a large change in the future demand or supply of the commodity. When this happens, it causes the futures price to jump or fall. As a result, there is a large divergence between the spot price and the futures price.
As mentioned earlier, there are certain factors that end up widening the spread between these two prices, including insurance, transportation, and other expenses. When a wide basis occurs, it indicates that inefficiencies are present. Traders can also create and take advantage of arbitrage opportunities. In most cases, though, the difference between prices ends up narrowing as contract expiration dates get closer.
Example of a Narrow Basis
Let's use a hypothetical example to show how a narrow basis actually works. Consider the case of an enterprising investor located between two towns:
- Town A has a crumbling infrastructure and a small number of local farms. Because of the poor infrastructure, the town’s inhabitants rely mostly on the local farms for their produce.
- Town B has relatively few farms but a very modern and efficient set of infrastructure.
Both towns are located relatively nearby to a regional delivery hub for the commodities futures exchange.
The investor speaks to locals in both towns and realizes that the basis for agricultural products is relatively wide in Town A and relatively narrow in Town B. During their research, the investor realizes that this is because the residents of Town A cannot economically bring in goods from the regional commodities depot, since the town's infrastructure does not permit them to do so. On the other hand, Town B has no problem bringing in these commodities, so their local produce stores are fully stocked with inexpensive products.
Sensing an arbitrage opportunity, the investor proceeds to regularly purchase goods in Town B, taking advantage of their low cost and narrow basis. He then personally delivers them several times a week to Town A, selling them at a higher price and taking advantage of that town’s wider basis.
By regularly repeating these deliveries, Town A’s local farmers are eventually forced to lower their prices to compete with the low-cost produce being brought in by the investor. In this sense, the investor’s arbitrage activities help to increase the efficiency of prices in Town A, leading to a narrow basis over time.
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