Basis: strengthening and weakening

The last lesson ended with a warning: a hedge swaps price risk for basis risk. This lesson explains what basis is, how it moves, and why that movement decides how well a hedge turns out.

What basis is

Basis = cash price minus futures price.

The CFTC glossary defines basis as the difference between the cash (spot) price and the price of the nearest futures contract, typically calculated as cash minus futures. It usually uses the futures contract next to expire.

Why are the two prices different at all? CME explains that a local cash price is the futures price adjusted for freight, handling, storage, and quality, plus local supply and demand. The NFA study outline lists transportation costs and differences in deliverable grades among the things that shape the basis.

Under and over

Basis can be negative or positive:

• Under: negative basis. Cash is below futures. A basis of minus 25 cents is “25 under.”
• Over: positive basis. Cash is above futures. A basis of plus 10 cents is “10 over.”

Made-up example: futures $5.00, cash $4.80. Basis = 4.80 minus 5.00 = minus $0.20, or 20 under.

Stronger and weaker

CME defines the direction this way:

• Strengthening: the basis becomes more positive or less negative. Cash is gaining on futures.
• Weakening: the basis becomes more negative or less positive. Cash is losing ground to futures.

Think of a number line: moving right (up) is stronger, moving left (down) is weaker. The words “narrow” and “wide” can confuse you, so check the sign.

Made-up examples:

The hedger’s net price

Here is the handy result: once a hedge is placed, the hedger’s final price equals

net price = futures price when the hedge was placed + basis when the hedge is lifted.

CME’s own wheat example shows it. A producer sells July wheat futures at $6.50 and expects his local basis at harvest to be 35 cents under, so he targets $6.50 minus $0.35 = $6.15.

• If the basis turns out 30 under (stronger), his net selling price is $6.20.
• If it turns out 40 under (weaker), his net selling price is $6.10.

The futures price he locked in did not change. Only the basis did, and it moved his result.

Who wins when basis moves

Short hedger (long cash, short futures): a stronger basis helps. Cash rose relative to futures, so the cash sale improved more than the futures leg lost (or lost less than the futures leg gained).

Long hedger (short cash, long futures): a weaker basis helps. CME’s example: a livestock feeder buys May soybean meal futures at $350 per ton and expects a basis of $20 over, for an expected cost of $370.

• Basis strengthens to $40 over: net cost $350 + $40 = $390 (worse).
• Basis weakens to $10 over: net cost $350 + $10 = $360 (better).

A memory hook: the short hedger is a seller and wants cash to be strong when selling; the long hedger is a buyer and wants cash to be weak when buying.

Long and short the basis

The CFTC glossary uses two phrases you should know:

• Long the basis: you have bought the cash commodity and hedged it by selling futures. That is the short hedger.
• Short the basis: you have bought futures as a hedge against a commitment to sell in the cash market. That is a long hedge position.

Being “long” something means you gain when it rises. The long-the-basis hedger gains when the basis strengthens, which matches the rule above.

Basis risk and convergence

The CFTC defines basis risk as the risk of an unexpected widening or narrowing of the basis between the time a hedge is set and the time it is lifted. CME notes that basis risk is typically much lower than outright price risk, which is why the swap is usually worth making, and it advises hedgers to keep historical basis records so their expectations are realistic.

Basis does not wander without limit. CME explains that as the delivery month approaches, cash and futures converge, because futures can be turned into cash at expiration. If they drift too far apart, arbitrage (buying in one market and selling in the other) pulls them back together.

Key ideas

• Basis = cash minus futures. Negative is under; positive is over.
• Stronger = more positive or less negative. Weaker = more negative or less positive. Check the sign, not the size.
• Net hedged price = original futures price + final basis.
• Short hedgers gain from a stronger basis; long hedgers gain from a weaker basis.
• Long the basis = long cash, short futures. Short the basis = long futures against a cash sale commitment.
• Hedging trades price risk for basis risk, which convergence near delivery helps keep in check.