What is Short The Basis
Short the basis is a futures strategy involving the purchase of a futures position to hedge against a future commitment to deliver the underlying commodity.
BREAKING DOWN Short The Basis
Opposite to a short hedge, shorting the basis implies that the investor will be taking a short position in the commodity and a long position in the futures contract. This strategy is used to hedge a position by locking in a future spot or cash price and thereby removing the uncertainty of rising prices.
The benefit of the short the basis strategy is that it locks in the price, so an increase in the commodities price will not affect the trader. For example, a manufacturer uses cotton as raw material. The cash price for cotton is $5.50 and the September futures price is $4.20. The manufacturer anticipates that he will need 200 quantity of cotton. To protect himself from price rise, he buys cotton futures contract at $4.20.
Futures prices reflect the price of the underlying physical commodity. Many futures have a mechanism for physical delivery. Therefore, a buyer of a futures contract has the right to stand for delivery of the commodity and a seller must be prepared to deliver on a short position if held to the delivery period. However, most futures contracts liquidate before delivery. Only a small number go through the actual delivery process. Successful futures contracts depend on convergence, the process by which futures prices converge with physical prices at the expiration of the futures contract or delivery date.
Short the Basis vs. Long the Basis
Basis Trading is a strategy used by elevators (and some farmers) looking to take advantage of favorable basis prices by exploiting the difference between the cash and futures. Grain elevators buy and sell grain all year around. When elevators make commitments to buy corn from farmers on the local market, elevators will also sell futures close to the cash delivery date to hedge themselves. When elevators make commitments to sell corn to a buyer, they also buy futures with expirations close to the cash delivery date to hedge themselves.
Many areas around the country have times of year when the basis is low and when the basis is high. If you understand your local market, there are times in the year where farmers and elevators may want to be “Long the Basis” (Long Cash, Short Futures) or “Short the Basis” (Short Cash, Long Futures). Basis traders look to be long the basis when their basis is low in their local market and they look to be short the basis when the basis is high in their local markets.