What Does Short the Basis Mean?
- The short the basis strategy involves simultaneously buying a futures contract and selling the underlying asset in the spot market to hedge against price appreciation.
- Shorting the basis locks in the price, which eliminates the impact of any increase in the commodities price at a later date.
- A long hedger wants a narrowing in the basis when they short the basis.
Understanding Short the Basis
Basis risk is the variation between the spot price of a deliverable commodity and the price of that commodity's futures contract with the shortest duration until maturity. It cannot be avoided if one wants to hedge their exposure to adverse price volatility, though it can be mitigated to a certain extent. This, in essence, is the goal of the long hedger when they "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. The commercial hedger deploys this futures strategy to lock in a future cash price, and thereby remove the uncertainty of rising prices that would affect their future commitment to deliver the underlying commodity. This type of hedger wants a narrowing in the basis since that will reduce the effective spot price of buying that commodity at a later date.
The benefit of the short the basis strategy is that it locks in the price, so an increase in the commodities price at a later date will not affect the trader. For example, a manufacturer who uses cotton as raw material anticipates that they will need a certain quantity at a defined point in the future. The spot, or cash price, for cotton is $3.50 and the specified futures contract price is $2.20. To protect themself from the price rising when they will need to buy it, the manufacturer buys the cotton futures contract at $2.20.
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 that is held to the delivery period. However, most futures contracts liquidate before delivery. Only a small number goes through the actual delivery process. Successful futures contracts depend on convergence, the process by which futures prices converge with physical prices at the expiration date of the futures contract.
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 differentials by exploiting the difference between the cash and futures prices. Grain elevators buy and sell grain all year round. 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 expiration dates 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.