Basis trading is a trading strategy usually consisting of the purchase of a particular security and the sale of a similar security (often the purchase of a security and the sale of a corresponding futures contract).
Basis trading is done when the investor feels that the two securities are mispriced with respect to each other, and that the mispricing will correct itself such that the gain on one side of the trade will more than cancel out the loss on the other side of the trade. In the case of such a trade taking place on a security and the futures contract, the trade will be profitable if the purchase price plus the cost of carry is less than the futures price. It is also called cash and carry trade.
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Basis of futures can be defined as the difference between the spot price and the futures price.[1] There will be a different basis for each delivery month for each contract. Usually, basis is defined as spot price minus futures price, however, the alternative definition, future price minus spot, is also used.
Adhering to the usual definition, if the basis for each contract is positive and increasing with tenure, the market is in backwardation. If the basis for each contract is negative and decreasing with tenure (increasing in absolute value) then the market is in contango.
Successful basis trading favorably balances the futures contract and the cash movement associated with the contract. It is with this in mind that traders analyze the activity level of prospective securities. As part of the approach the deal is put together with a long cash position 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.
It is also possible to position a sale in the same manner as the purchase described above. Again, 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. Whether buying or selling, traders work to maintain a favorable balance that best allocates the given financial resource to maximize profit. The best profits are produced when there is a chance to sell just before the futures date arrives. Generally, this allows the investor to take his profit and roll the principal over into another trade.
In option trading, basis is used to evaluate the value differential between a call option and a put option. Also referred to as the reversal/conversion rate, it is calculated by determining the costs and benefits of being long or short the underlying security.