What Is Basis Trading? A Complete Guide
Data finds that only 56% of Americans own stock. And while owning stock isn't the only way to invest or build wealth, it's definitely one of the more popular options. Read on to find out more.
What is basis trading? It is one of the less common investing strategy (among options, futures etc) that is gaining traction. In this article, you will learn everything you need to know about basis trading for beginners.
Investing Terms To Know
Before jumping into basis trading, it's important to understand some key investing terms.
The first is "security." A security is something you can trade. This includes stocks, bonds, banknotes, options, futures, and commodities.
The next term is "long position."
A long position is when a trader purchases and owns stocks, commodities, etc., and expects good trading options. Most likely, the trader expects the investment to increase in value. Traders refer to the long position as "long" or "going long."
The third term is "short position."
The short position is when a trader expects a security to fall in price. As a result, the trader will sell off the security to repurchase it at a lower rate. After selling the securities, the trader is "short" of the securities.
Another term to know is "futures."
Futures are derivative financial contracts. The person who holds the contracts must buy or sell the asset at a predetermined future date and price. Futures allow traders to estimate the direction of a security, commodity, or other financial instruments.
What Is Basis Trading?
Basis trading is a strategy where investors try to profit from the mispricing of securities. First, you buy a commodity at its spot price (long position). Then, at the same time, you establish a short position through derivatives. These can be futures or options contracts.
The two prices should meet, and there is a profit at that point. Investors execute a basis trading transaction to profit from the perceived mispriced security while avoiding potential losses.
The trader takes the long position on the undervalued commodity and the short position on the overvalued derivative.
Some traders also call this a cash-and-carry trade.
Case Study
Basis trading is most common in agricultural futures. However, investors can also do basis trading for precious metals, interest rate produces, and indexes. Basis trading is becoming more popular in the crypto market too, even though these markets aren't as mature or liquid as commodities.
Anyway, let's say a soybean farmer is a few months away from delivering his crop. The farmer notices that he will have an excellent crop because of good weather conditions. So he starts to fear that there will be a drop in the soybean price because of an oversupply.
The farmer can sell futures contracts to cover the number of soybeans he wants to sell. The current spot price for soybeans is $14 per bushel. The futures contracts that expired two months out were trading at $15 per bushel. So the farmer could lock in a price with a +$1 basis.
The farmer expects the futures contract price ($15) to fall and come closer to the spot price ($14) or the basis.
Basis Trading Benefits
A great advantage to basis trading is reducing losses. Traders can enter into a contract to ensure the minimum selling prices of the commodity. Basis trading can help secure the minimum price.
It acts as a protection against price fluctuations. It also prevents losses if the commodity falls below the intended sale price.
Further, an increase or decrease in price will not affect the minimum profit. This helps to reduce risk.
However, traders need to close their positions by the end of the day. They should not hold any positions overnight when day trading futures and doing basis trading. This is because futures open at a different price than what they closed at the previous day.
Price fluctuations in the market can cause unanticipated losses or profits.
Basis Trading Limitations and Risks
While traders can reap significant profits from basis trading, our guide wouldn't be complete without discussing the downfalls and risks.
Basis trading requires leverage. Leverage is the use of borrowed financing or capital to fund investments. It allows traders to increase their potential profit. However, using leverage means there is a high risk.
If the trader short sells the commodity under a futures contract and the spot price increases above the price, the trader has to bear the loss.
Additionally, if the trader enters a long position and the spot price falls to less than the contracted price, the trader must bear the loss. This is because the purchaser can buy from the open market.
A price basis risk occurs when the prices of an asset and its futures contract don't move in tandem with each other.
Basis trading is not for someone who wants a hands-off approach to investing. Day traders who do basis trading need to follow strict directions and investing tips to succeed. It's easy to make marginal traders or overtrade in the futures market.
Additionally, commissions can add up with day and basis trading.
Learn More and Start Investing
Now that we've answered the question, "What is basis trading?" you have a better idea of how traders make a profit from undervalued securities. You can use these basis trading tips and feel more confident in basis trading on your own.
If you're ready to start investing, then sign up for the Spiking Live Webinar now! With our courses, membership, and investing tools, you will gain an upper hand in investing in securities and carrying out different trades. Start saving for your future by investing today.
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