Basis Trading: A Valuable Tool in Commodity Trader’s Arsenal

Prices of various assets – stocks, commodities, cryptocurrencies – vary between the spot market and the futures market. If there is a price disparity between two financial products representing the same asset, there is always the potential to benefit from the arbitrage. In this article, we will cover a trading method that exploits this price disparity and is often used to hedge risks or improve profits in commodity markets.

What Is Basis Trading?

At the most essential level, basis trading is a strategy of taking advantage of the price differential between an asset’s spot price and its futures price. In basis trading, either you buy an asset on the spot market and simultaneously sell the asset’s futures contract, or, alternatively, sell an asset on the spot market and simultaneously buy its futures contract.

Let’s say you are trading gold, and its current spot price is $1,930, while futures contracts for gold are available for $1,940. Let’s also assume that you have good reasons to believe that the market’s uncertainty towards gold will increase in the near future. This would lead to a narrowing of the price differential between spot gold and gold futures. It might also lead to a decline of the futures prices below the spot price. Using the basis trading strategy, you buy spot gold and sell the futures contract for it. By doing so, you lock in the price differential between gold’s spot and futures prices. In this example, you are doing what is known as a long basis trade.

In turn, a short basis trade occurs when you sell an asset and buy its futures contract. In this case, you are betting on gold increasing in price in the near future.

Basis trading is most applicable to markets where high levels of seasonal volatility or other forms of significant uncertainty are present. Such uncertainty often leads to volatility in futures prices. These markets are ideal for the application of basis trading. This trading strategy is highly applicable to many commodity markets. Many commodities, especially agricultural products, have inherent uncertainty built into them due to seasonal changes and supply fluctuations.

Besides commodities markets, basis trading is growing increasingly popular in crypto trading. Although crypto markets don’t have the same level of liquidity as commodities markets, the relatively new Bitcoin and other crypto futures are making basis trading a possible strategy in this area as well.

What Are the Pros and Cons of Basis Trading?

Basis trading’s pros and cons are specific to a particular market where it might be used. Basis trading in general is probably less relevant for stock traders. For commodity traders, there is a host of benefits and drawbacks to basis trading that are highly specific to their market. For crypto traders, the pros and cons of basis trading are somewhat different from what might be applicable to an agriculture or gold trader.

In general, the main pros of basis trading include:

1. Protecting yourself from future price changes caused by seasonal factors. This is most relevant for agricultural commodity traders.

2. Ability to use leverage, a usual companion to futures products.

3. Potential for good profits in markets with high levels of liquidity and frequent futures price fluctuations. Again, this is more applicable to commodities traders than crypto traders due to the lower liquidity of the crypto market.

4. Potential for good profits in markets with a large disparity between spot and futures prices. This benefit of basis trading is specifically applicable to the crypto market. As we noted above, cryptocurrencies don’t have the level of liquidity available in commodities markets. However, this could be offset, at least partially, by the large differences in spot and futures prices of cryptos. It is not unusual for cryptocurrencies to have differences between these prices to the tune of 30% or more.

The main cons of basis trading are:

1. The use of leverage, inherent in futures products, might make basis trading a highly risky activity. Traders without significant experience with leverage products might be putting themselves at risk of large losses.

2. Basis trading is a form of very active trading. It is most suitable for day traders. This is not a trading method that you could use in a hands-off way with little time commitment.

3. Potential for large losses due to the volatility of commodities and crypto markets. Although basis trading is one way to reduce volatility, you still need to get the direction of the asset’s price right. In commodities markets, a number of factors can lead your target asset’s price sharply in the opposite direction. These factors may include abrupt weather changes that affect crops, political instability that leads to supply disruptions, and in general, sensitive nature of many commodities’ prices.

4. In crypto markets, you might also run into the problem of lower overall liquidity, a less than ideal scenario for effective basis trading.

5. Also specifically for the crypto market - if you want to use basis trading with anything other than the top coins, BTC and ETH, you might have problems finding relevant futures products at all to apply your strategy. That is if you want to stick with a regulated exchange, of course. If you don’t mind a foray outside of the regulated exchange markets, you might consider the top cryptocurrency exchanges. Most of these offer futures in a variety of popular crypto coins.

Basis trading can be a very profitable activity. However, do note that it is from a family of rather risky trading methods. The main market where it is used, commodities, is known for its inherent volatility. Additionally, the use of leverage amplifies the risks involved. Keep in mind these peculiarities if you decide to adopt this trading method.