WHAT IS 'Narrow Basis'

Narrow basis refers to the convergence of the spot price and futures price of a commodity. It implies an efficient and liquid market.

BREAKING DOWN 'Narrow Basis'

A narrow basis refers to a relatively small spread in price between the spot price of a commodity and a short-term futures contract on that same commodity. Basis carries several different meanings in the investing world, but the following formula is appropriate for the purposes of this discussion:

Basis = spot price - futures price

A futures contract binds a buyer and seller to an agreement to exchange a specific quantity of a commodity, at an agreed-upon price, at a point in the future. 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 futures price and the two should converge at the expiration date of the contract. Under these conditions, the value of the future to both buyer and seller shrinks to zero as the expiration date, since the futures prices allows no advantage to either buyer or seller at that point.

In the imperfect world, basis is affected by several factors which may be beyond the control of any participant in the futures market. Transportation, holding, and interest costs add a margin to the costs of the product itself, and unforeseen weather conditions present a persistent threat to the stability of any market. For agricultural products, proximity to harvest can 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.

A narrowing basis: an example

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 could be due to an expected increase 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 would be a narrowing basis.

When basis narrows from below, moving from $0.25 to $0.10 for example, it can be described as a strengthening basis. This 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.

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