Explain Basis

Hi All,

I was reading about basis in commodities. It said that if spot price is above future price it is +ve basis and if spot is below future price then it is -ve basis. It also mentioned about if spot price moves faster than future price then basis is strengthing.

Could someone explain the concept of basis in detail and what does it imply and what does it tell us about the market if basis reduces /increase.

Rgds

Rahul

Hi rahulg77,

Basis is defined as the difference between the cash price and the price of related futures contract for a specified time and period.

Simply put a strengthening basis shows a strong demand for that product at that time and a weak basis the opposite.

Hi Vince,
I enjoy reading your posts. But this time I have to disagree with you.
Theoretically, the 'basis' is simply the financing cost that the buyer of a futures contract pays the seller. In India, the annualised basis (cost of carry) should be around 7-8%, or higher depending on the incremental borrowing cost.
Practically, the basis diverges from the borrowing cost, because of speculation, hedging etc. by some large players taking a directional bet on the market.
When the basis (futures minus spot) is very high, cash and carry arbitrage evens things out.
When the basis is highly negative, reverse cash and carry can be employed. The problem with this is that absence of short-selling in India constrains arbitrageurs.
For non-equity products like commodities, you have to consider storage costs and other convenience yields. This can make the futures always go at a discount to the spot.

Just looking at the basis does not give one a clear idea about the direction of a stock/ index. It has to be looked at in conjunction with the price, volume and open interest.

Hi Ivanboesky,

You are right about the above, but I was only attempting to define it in laymans terms, since I felt that anything beyond that would be beyond the scope of this discussion.

Okay Vince! Point taken.