Basis Trade – How It Works, Examples & Similar Strategies

Written By

Dan Buckley

Updated

Jul 10, 2024

The basis is a trading strategy that tries to exploit the temporary price differences between a futures contract and its underlying asset (e.g., commodities, bonds, stocks).

Basis trading belongs to the broader category of arbitrage, convergence, or relative value strategies.

Arbitrageurs try to capture small but relatively risk-free profits arising from price discrepancies in related financial instruments.

Key Takeaways – Basis Trade

Profit from Price Differences

Basis trade capitalizes on the price discrepancies between spot prices and future contracts of an asset.

Traders try profit when these values converge by going long the cheaper one and short the more expensive one.

Risk Mitigation Strategy

It serves as a hedge against price volatility by simultaneously holding opposing positions in spot and futures markets.

Market Insight Required

Successful basis trading demands deep understanding of market trends, timing, and asset behavior to effectively exploit temporary inefficiencies.

Objective

The primary reasons traders explore basis trades are:

Risk Reduction

Basis trading can be used to hedge existing positions.

If a trader holds the underlying asset, they might initiate a basis trade to offset some of the risk associated with potential price fluctuations in that asset.

Examples

Farmers might grow corn and soybeans and reduce the risk of random price fluctuations by shorting in the futures market when their harvests will be delivered. This locks in their profit.

Also, a jeweler who owns gold, silver, precious metals, and gemstones might short the futures market to hedge against price fluctuations in the price of the jewelry.

Profit Potential

Basis trades specifically attempts to take advantage of temporary price differences between the futures contract and the underlying asset.

If the trader anticipates these prices converging, they try to profit from this movement.

Mechanics of the Basis Trade

Trade Setup

Asset Selection

Basis trades can work with various underlying assets, including bonds (especially Treasury securities), commodities (like oil or agricultural products), currencies, or indices.

Traders typically look for high liquidity in both the underlying asset’s spot market and its corresponding futures contracts.

Timing and Conditions

Key conditions favor basis trades:

Convergence – The fundamental expectation of a basis trade is that the futures contract price will eventually converge with the underlying asset’s spot price upon expiration.
Temporary Discrepancy – The trader looks to spot significant but temporary pricing differences between the two. This gives the potential for profit as those prices align.
Market Inefficiencies – Basis trades often arise from market dislocations or inefficiencies that can create price discrepancies.

Execution

Identifying Opportunity

The trader spots a price difference between the futures contract and the spot price of the underlying asset that seems exploitable (taking into account transaction costs).

Opening Positions

Long Leg – Buy the undervalued asset (either the futures contract or the asset itself in the spot market).
Short Leg – Sell the overvalued counterpart (either the futures contract or the spot asset).

Monitoring

Closely track the price of the futures contract along with the spot price of the underlying asset.

Here, the trader focuses on how the basis evolves.

Closing Positions

If the basis converges – Close both positions, ideally profiting from the price difference narrowing.
If the basis widens – Exit the trade to cut losses by either closing positions or adjusting them using hedging strategies.

Risk Management

Basis Risk

As the basis can fluctuate, there’s always a risk that the difference between the futures and spot prices might widen instead of narrow.

This can erode profit or even create a loss.

Hedging

Basis traders often use hedging techniques to reduce basis risk.

This might involve using options or taking additional offsetting futures positions.

Stop-Loss Orders

Setting stop-loss orders can help automate the process of exiting a trade if the basis moves unfavorably to limit potential losses.

Margin Requirements

Futures trading involves margin.

Traders need to be aware of margin requirements and the potential for margin calls if the trade moves against them or if market volatility increases.

Basis Trading Example

Identifying Mispricing

A trader notices the price of a corn futures contract is higher than the current spot (cash) price of corn.

The Trade

The trader short-sells the overvalued corn futures contract and simultaneously buys the relatively underpriced corn in the spot market.

Convergence

Over time, as the futures contract nears expiration, its price typically converges with the spot price of the underlying asset.

Profit

If the convergence occurs as expected, the trader can buy back the futures contract at the lower converged price and deliver the corn purchased on the spot market, pocketing the difference.

Important Factors

Basis Risk

The basis (the difference between spot and futures prices) isn’t constant and can fluctuate.

There’s always a risk that the basis might not move as the trader anticipates.

This can reduce profit potential or even lead to losses.

Transaction Costs

Trading incurs fees and commissions that need to be factored into the profitability of a basis trade.

Market Liquidity

The ability to execute trades quickly and efficiently depends on the liquidity of both the futures and spot markets.

What Causes the Basis Trade to Go Wrong

Basis trades, while seeking to exploit price dislocations, are still subject to market risk.

Here’s how they can go wrong.

Unexpected Basis Widening

The fundamental risk in a basis trade is that instead of the basis narrowing (i.e., the futures price converging with the spot price), the price discrepancy widens.

This widens the gap between the long and short legs of the trade, leading to a loss.

Several factors can trigger this:

Supply/Demand Shocks – Unexpected changes in the supply or demand for the underlying asset can dramatically shift both spot and futures prices, causing unpredictable basis movements.
Interest Rate Changes – Interest rate fluctuations, particularly if sudden or large, can heavily impact the pricing of futures contracts, especially in fixed-income basis trades.
Carrying Costs – Unanticipated spikes in storage, transportation, or insurance costs associated with holding the underlying asset can pressure the basis.

The basis trade has had bouts of doing poorly in “crisis” market scenarios like the 1997 Asian crisis, 1998 Russian default (led to LTCM famously blowing up from the basis trade), and 2008 financial crisis.

Market Illiquidity

If there isn’t adequate liquidity in either the futures market or the spot market of the underlying asset, it can become difficult to exit your trade at the desired price.

This can lead to either having to accept a wider basis or being unable to close the trade altogether.

Unforeseen Events

Geopolitical events, natural disasters, or major announcements that disrupt the underlying asset’s market can create volatility and unpredictable shifts in prices.

This can disrupt any expected convergence.

Transaction Costs

While factored in initially, unexpectedly high commissions, fees, or spreads can eat into the profitability of the trade or even turn a winning trade into a loss.

Additional Factors

Leverage

Futures trading often involves margin, which amplifies both gains and losses.

If a basis trade moves sharply in the wrong direction, a leveraged position can lead to large losses.

Also, if a trader is too big a part of its own market, that can make entry and exit difficult (a factor LTCM overlooked in its basis trade blowup).

Timing

Basis trades often have a time horizon based on the expiration date of the futures contract.

Misjudging when the basis convergence is likely to occur can result in missed opportunities or holding the trade longer than anticipated and incurring increased risk.

Treasury Bonds Basis Trade

The Treasury bond basis trade starts with the concept of on-the-run and off-the-run bonds.

Understanding On-the-Run vs. Off-the-Run

On-the-Run

These are the most recently issued Treasury bonds or notes of a particular maturity (e.g., 2-year, 10-year, 30-year).

They boast the highest liquidity and are often the benchmark for Treasury yields.

Off-the-Run

These are older Treasury bonds or notes of the same maturity.

While still actively traded, they’re generally less liquid than their on-the-run counterparts.

Treasury Bond Basis Trade: Utilizing the On-the-Run / Off-the-Run Discrepancy

A common basis trading strategy in Treasuries involves exploiting the price difference that often arises between on-the-run and off-the-run securities.

Here’s the general setup:

The Premise

Due to their higher liquidity, on-the-run issues usually trade at a premium – higher price, meaning slightly lower yields – compared to similar maturity off-the-run issues.

Basis traders assume that this premium should decrease over time as the on-the-run bond ages and eventually becomes off-the-run itself.

Trade Setup

Long Leg – Buy a cheaper off-the-run Treasury bond in the spot market.

Short Leg – Sell a Treasury futures contract whose underlying deliverable asset aligns with the maturity of the purchased off-the-run bond. Since new futures contracts are typically tied to the on-the-run issue, this constitutes a short position in the relatively more expensive on-the-run.

Anticipated Outcome

The trader expects the price difference between the off-the-run bond and the on-the-run (reflected in the futures contract) to narrow.

This allows them to profit by purchasing back the futures contract at a lower price and selling the off-the-run bond, which has presumably appreciated with the narrowing basis.

Important Considerations

CTD Factor

Treasury futures have a “Cheapest-to-Deliver” (CTD) option.

The short position holder can choose from a basket of eligible issues.

This adds complexity, as the trader needs to factor in which bond is likely to be the CTD when the futures contract expires.

Rollover

Futures contracts have expiry dates.

As the contract nears expiry, traders often “roll” their positions into the next contract for a similar maturity to maintain the trade.

Relative Value Strategies Similar to the Basis Trade

Let’s look at some relative value strategies that share similarities with the basis trade.

We’ll look at the focus of the trading style, what a typical trade might be, and similarities to the basis trade.

1. Convertible Arbitrage

Focus – Exploiting pricing inefficiencies in a company’s convertible bonds versus its common stock. Convertible bonds can be converted into a fixed number of the company’s shares under certain conditions.
Typical Trade – A trader might buy a seemingly undervalued convertible bond while simultaneously shorting the company’s stock.
Similarities to Basis Trade – Relies on the relationship between two linked securities and seeks to profit from temporary differences in their prices.

2. Merger Arbitrage (also known as Risk Arbitrage)

Focus – Capitalizing on the price spread between a target company’s stock price and the acquisition offer price in an announced merger or acquisition.
Typical Trade – A trader would purchase shares of the target company (long position) while potentially shorting the acquiring company’s stock if there are concerns about deal completion.
Similarities to Basis Trade – Involves betting on the convergence of prices between two related assets or entities. The trade profits if the deal ultimately goes through and the prices align.

3. Fixed-Income Relative Value

Focus – Identifying mispricings between different fixed-income securities. This could include bonds of varying credit quality, maturities, or types (corporate bonds, government bonds, mortgage-backed securities, etc.).
Typical Trades – Involve going long an undervalued bond and shorting a similar but overvalued bond.
Similarities to Basis Trade – Leverages discrepancies between related assets, trying to gain from price normalization.

4. Volatility Arbitrage

Focus – Profiting from differences between the implied volatility (the market’s expectation of future price fluctuations) priced into options and the realized volatility of the underlying asset.
Typical Trades – Can involve buying undervalued options and selling overvalued options, or combinations of options and the underlying asset to create delta-neutral positions.
Similarities to Basis Trade – Trades are designed to profit from the normalization of price relationships due to perceived distortions in the market.

5. Statistical Arbitrage

Focus – Uses mathematical and statistical models to identify fleeting price discrepancies across a wide range of highly correlated assets.
Typical Trades – Involve numerous small trades based on computationally determined pricing anomalies, relying on the statistical likelihood of prices reverting to historical norms.
Similarities to Basis Trade – Also an arbitrage strategy, though statistically driven rather than focused on the fundamental relationship between specific assets.

Note: All relative value strategies involve some degree of risk. Market conditions can change and anticipated relationships or price convergences might not materialize as predicted.