Understanding Basis: The Difference Between Futures Price and Spot Price

What is Basis?

Basis is the difference between the futures price and the spot price of an underlying asset.

Simply put, it's the gap between what an asset is worth now (spot price) and what it's expected to be worth in the future (futures price).

For instance, if the current price of Bitcoin (spot price) is $30,000 and the futures price (price agreed for future delivery) is $32,000, the basis is $2,000.

Key Terms Explained

1. Spot Price:

   • The current market price at which an asset can be bought or sold immediately.
   • Think of it as the price you pay to buy something right now.

2. Futures Price:

   • The agreed-upon price for buying or selling an asset at a future date.
   • It reflects what traders believe the asset will be worth at that future time.

3. Basis:

   • The difference between the futures price and the spot price.
   • Basis = Futures Price - Spot Price

Why is Basis Important?

Understanding basis is important for several reasons:

• Indicator of Market Sentiment: Basis can indicate whether the market is bullish (positive) or bearish (negative) about the future price of an asset.
• Hedging Tool: Traders and investors use basis to hedge against price changes in the underlying asset.
• Arbitrage Opportunities: Differences in basis can present arbitrage opportunities, where traders can profit from the price discrepancies.

Example to Understand Basis

Let's break it down with a simple example involving Bitcoin:

Spot Price Scenario:

• The current price of Bitcoin (spot price) is $30,000.

Futures Price Scenario:

• The futures price of Bitcoin for a contract expiring in three months is $32,000.

Calculating Basis:

• Basis = Futures Price - Spot Price
• Basis = $32,000 - $30,000
• Basis = $2,000

In this example, the basis is $2,000, meaning the futures price is $2,000 higher than the spot price. This indicates that traders expect the price of Bitcoin to rise in the next three months.

Types of Basis

1. Positive Basis (Contango):

   • Occurs when the futures price is higher than the spot price.
   • Indicates that traders expect the price of the asset to increase in the future.
   • Common in markets with high storage costs or interest rates.

2. Negative Basis (Backwardation):

   • Occurs when the futures price is lower than the spot price.
   • Indicates that traders expect the price of the asset to decrease in the future.
   • Can happen due to short-term shortages or high demand for the spot asset.

Factors Influencing Basis

Several factors can influence the basis, including:

• Supply and Demand: Changes in supply and demand for the underlying asset can affect both spot and futures prices.
• Storage Costs: For physical commodities, storage costs can cause futures prices to be higher than spot prices.
• Interest Rates: Higher interest rates can lead to a positive basis as it costs more to hold the asset over time.
• Market Expectations: Traders' expectations about future market conditions can impact the futures price, influencing the basis.

How Traders Use Basis

Traders use basis in various ways to inform their trading strategies:

1. Hedging:

   • Traders use basis to hedge against price fluctuations in the underlying asset.
   • For example, a farmer might sell futures contracts to lock in a price for their crop, protecting against potential price drops.

2. Speculation:

   • Speculators try to profit from changes in basis by predicting future price movements.
   • If they believe the basis will widen (futures price will increase more than spot price), they might buy futures contracts.

3. Arbitrage:

   • Arbitrage traders look for price discrepancies between the spot and futures markets.
   • They can buy the asset at the spot price and sell futures contracts if the basis is positive, locking in a risk-free profit.

Real-Life Example: Oil Market

The oil market often provides clear examples of basis:

Spot Price Scenario:

• The current spot price of crude oil is $70 per barrel.

Futures Price Scenario:

• The futures price for crude oil contracts expiring in six months is $75 per barrel.

Calculating Basis:

• Basis = Futures Price - Spot Price
• Basis = $75 - $70
• Basis = $5

In this example, the basis is $5, indicating a positive basis (contango). Traders expect the price of oil to rise in the next six months, possibly due to anticipated higher demand or lower supply.

Conclusion

Basis is a fundamental concept in trading that represents the difference between futures and spot prices.

It provides valuable insights into market sentiment, helps with hedging, and creates opportunities for arbitrage.

By understanding basis, you can make more informed trading decisions and better navigate the complexities of futures and spot markets.

Whether you're a beginner or an experienced trader, keeping an eye on basis can enhance your trading strategies and help you stay ahead in the market.

Stay informed, stay strategic, and happy trading!