What is Wide Basis
A wide basis is a condition found in the futures market where the spot price of a commodity is not close to the futures contract price for that same commodity. A wide basis can either be positive or negative. A negative basis is when the spot price is lower than the futures price. A positive basis is when the spot price is above the futures price. There is usually a difference between the spot price and a futures contract price, except when the contract is at expiration, but it is the degree of the basis that determines if it is a wide or narrow.
Breaking Down Wide Basis
A wide basis suggests a mismatch between supply and demand. If short-term supply is low, due to weather for example, but demand is high, cash prices will rise relative to futures prices, because down the road the supply situation is likely to improve. If short-term demand is low, but supply is high, cash prices will fall relative to futures prices.
Markets and Wide Basis
The spot price and futures price should converge at maturity of the futures contract, otherwise, there is an arbitrage opportunity. The current basis, as well as the knowledge that a wide basis will dissipate as the futures contract nears expiration, can aid traders in making trading decisions.
If a futures contract has a wide negative basis, that means the futures price is above the spot price. As that contract nears expiration the futures price will either need to come down, or the spot will need to rise. If spot price appears stable, then futures prices will likely fall into expiration so that at expiration the futures contract price and the spot price converge.
If a futures contract has a wide positive basis, that means the futures price is below the spot price. Traders know that at expiration the spot and futures contract price will converge. If spot prices are expected to stay stable, then the futures contract will rise toward the spot price as expiration approaches. If the spot is expected to rise, the futures could see a big rally, as they try to catch up to spot as expiration approaches. If spot falls, the wide basis may simply narrow, without the futures contract falling that much.
Looking at the basis is important to hedgers, as well as speculators, since basis can change between when a hedge is implemented and when the trades are exited. Hedgers look at whether basis is likely to widen or narrow, or, they can re-adjust their futures positions as basis changes.