Long the Basis

What Is Long the Basis?

Long the basis is a trading strategy in which an investor who owns or has bought a commodity hedges their investment, or gives themselves a little buffer against potential market fluctuations, by selling futures contracts on that commodity. Taking such action provides a guaranteed price at which they may sell their commodities if the market price moves against their underlying position.

Understanding Long the Basis

Long the basis, by definition, means the investor must be bullish on a particular commodity and usually is looking to hedge their bullish position.

For instance, a gold-mining company maintains a significant position in the precious metal. However, the price of gold is susceptible to market pressures and is likely to fluctuate at times. To hedge against adverse changes, the company may choose to buffer its bullish stance through the sale of futures contracts and thus lock in a guaranteed range of value.

In contrast, a trader who is bearish on a commodity may enter into a short the basis trade. Shorting the basis implies the investor will be taking a short position in the commodity and a long position in the futures contract. This strategy is used to hedge a position by locking in a future spot or cash price and thereby removing the uncertainty of rising prices.

Both the long-the-basis and the short-the-basis trades are basis trading strategies. Basis trading relates to a trading strategy in which a trader believes that two similar securities are mispriced relative to each other, and the trader will take opposing long and short positions in the two securities to profit from the convergence of their values.

A bullish investor looking to hedge their position would be considered long the basis; a bearish investor looking to hedge would be considered short the basis.

Example of Long the Basis

It is August at the Smith family farm, and the Smiths have agreed to sell their soybean crop to a wholesaling group, Soy Tofu. The contracted price is $400 a ton, which is the current cash price. The wholesalers think they have gotten a good deal, believing that soybean prices will rise in the coming months. However, they also are a bit concerned about what it would mean for their profit, at resale, if bean prices were to fall.

As a result, Soy Tofu decides to sell soybean futures at $425 per ton. The wholesalers are now long the basis, meaning they are long soybeans and short soybean futures. If the price falls, being long the basis will guarantee a favorable price at which they can resell. Their cost basis, in this case, is negative $25, or cash of $400, minus futures of $425.

The wholesalers are making a trade-off, however. They are exchanging price risk for basis risk — that is, the risk that the price of soybeans and soybean futures will not move in lockstep. The wholesalers will profit if the differential between soybean and soybean futures prices narrows. However, a widening of this differential will result in a loss.

Rather than for hedging purposes, the wholesalers may also choose to go long the basis by speculating about the price differential between soybeans and soybean futures. Perhaps they believe local prices for soybeans will rise. If the price reaches $450 while the futures price advances only to $430, their net proceeds due to the narrowing of the basis will be $25 on the soybeans, and negative $5 on the soybean futures, for a total of $20. Their bullish bet will have paid off.

However, if the price of soybeans stays at $400, while the futures price rises to $435, the basis will be negative $35. The widening of the basis from the previous negative $25 will result in a loss of $10 per ton.

Notably, it is also possible for the Smith family to go long on the basis, as well. To do so, they would hold their soybeans in storage and sell soybean futures. The family may choose to do this if they think local soybean prices will rise.