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What is Basis Trading?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 10 September 2016
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Basis trading is all about playing the extremes of the cash and futures market. As an arbitrage strategy that demands the implementation of a long cash position that is coupled with a short position in the futures contract, the point of basis trading is to maximize generated revenue from the venture while keeping expenses at a minimum. Sometimes referred to as a cash and carry trade, this type of arbitrage position has a lot of potential to reap big rewards, if the timing is right.

The process of basis trading is all about getting the right mix between the futures contract and the cash movement that is associated with the contract. This mean looking very closely at the activity level of securities that may be a good fit for the strategy. Once a security has been identified as being a good candidate, the purchase begins. As part of the approach the deal is put together with a long cash position that is matched with a short position on the futures. In a sense, what is happening is that the investor is buying cash and carrying it to the futures date, where it will be delivered into the contract.

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Along with positioning the purchase in this manner, it is also possible to position a sale in the same manner. Again, the basis trading involves the combination of the long cash position and the short futures. Money for financing the long position can be borrowed and repaid, using the investment as the collateral. The key is to maintain the balance whether buying or selling, so that financial resources are used to best advantage and the chances for making a profit are higher. The best profits are produced when there is a chance to sell just before the futures date arrives. Generally, this allows the investor to make a nice profit and take the principle and reinvest it into another trade that is created using the basic approach of basis trading.

Careful attention must be paid to the position of futures, both when buying and selling. Failing to understand the history of the movement of the futures could lead to choosing the wrong investment and derailing the process before it ever gets underway. This could also lead to a situation where the funds borrowed to manage the long position could end up not being covered by the profit made from the venture. Tracking futures activity is essential to successfully utilizing a basis trading technique.

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ysmina
Post 3

@turkay1-- Yes, but let's not forget that the futures date is a set date and that investors make the most profit when they sell right before that date. That is another reason why timing is important.

Also, basis trading never ends. The profit from one investment goes directly into another investment and on and on. Being a basis trading investor is not an easy job! They have to be constantly on the move, finding good investments and analyzing what the future securities will look like.

candyquilt
Post 2

@simrin-- You're absolutely right, that's why it's called cash and carry trade. It's when the investor makes a calculation about the cost of the trade and what he's going to profit from it in the future. If the futures price is high enough that it will completely cover the costs of buying (including the security) and has something left over, the investor invests.

Timing is important because as you know the market is always fluctuating. If the futures price shifts in a negative way for the investor, he won't profit and might even lose money. That's why calculation and timing is very important.

SteamLouis
Post 1

If I understand this right, basis trading involves putting up a security as the buyer and also taking security as a seller right?

I'm a little confused about how this makes trade more profitable.

I think it would be profitable in two situations. One, if you were selling something, took security and then the buyer changed his mind, leaving you with the goods and the security. It would also be profitable if the trader first bought and then sold something giving less security while buying and taking more while selling. Then there would be profit made from the trade.

Is the latter circumstance what the article is referring to about picking the right time for basis trading?

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