Basis Trading

Definition

The term basis trading refers to an arbitrage strategy used by investors to profit from the mispricing of two related securities.  The arbitrager believes that as the mispricing of the securities experience a correction over time, there will be a gain on one side of the trade that will more than offset the loss on the other side of the trade.

Calculation

Trade Basis = Cash Price of a Security - Futures Price of a Security

Explanation

When an investor attempts to profit from a very small basis change in price over time, the approach is referred to as basis trading.  Typically, the strategy involves an investor taking opposing long (buy) and short (sell) positions in the two securities.  Since the investor is executing the trade based on a relatively small basis change in price, the transaction normally involves some form of leverage too.

For example, there may be mispricing of a security relative to its futures contract.  As the value of the security and its futures contract converge over time, the trader can profit if the total purchase price of the security, less all of the associated fees and carrying cost, is greater than the security's futures price.

Related Terms

basis point, basis