What Is a Wide Basis?
Let me explain what a wide basis means in futures trading—it's a market condition where the local cash or spot price of a commodity sits relatively far from its futures price. This is the direct opposite of a narrow basis, where those spot and futures prices stay close together.
You should know it's normal to see some difference between spot and futures prices because of elements like transportation costs, holding expenses, interest rates, and unpredictable weather. We call this difference the basis, and no matter how wide it gets, it usually converges as the futures contract's expiration date draws near.
Key Takeaways
- A wide basis is a market condition where the gap between spot prices and futures prices is relatively large.
- Such a divergence between spot price and futures price may be associated with illiquidity or high carrying costs.
- Basis inevitably reduces as the futures contract approaches its expiration date; any gap that remains would produce opportunities for arbitrage profits.
Understanding Wide Basis
At its core, a wide basis points to a mismatch between supply and demand. If short-term supply drops low—say, because of bad weather—then local cash prices can rise compared to futures prices. Conversely, if short-term supply surges, like with a bumper harvest, local cash prices might drop relative to futures prices.
In either case, you end up with a wide basis, where the basis is just the local cash price minus the futures contract price. This gap should shrink gradually as the futures contracts approach expiration, because if it doesn't, traders could exploit arbitrage opportunities between local cash and futures prices.
When the basis moves from a negative figure like -$1 to something less negative like -$0.50, that's called a strengthening basis. If it shifts from a larger positive to a smaller positive, that's a weakening basis.
Important
Generally, a narrow basis aligns with a liquid and efficient market, while a wide basis ties to one that's relatively illiquid and inefficient. That said, some variation between local cash prices and futures prices is normal and expected.
Real World Example of a Wide Basis
Imagine you're a commodities futures trader eyeing the oil market. You see the local cash price for crude oil at $40.71, while the futures price for a contract maturing in two months is $40.93. Here, the basis is narrow at just -$0.22 (spot minus futures), which fits because the contract trades heavily and expiration is only two months away.
But look further out, and you start seeing wide bases. For the same contract delivering in nine months, the futures price hits $42.41, creating a wider spread of -$1.70. This could stem from various factors, like traders anticipating higher oil prices due to reduced supply or boosted economic activity. Regardless, that basis will almost certainly narrow as the contract date gets closer.
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