Basis Applied in Hedge: Understanding Strategies and Risks

We recently explained in our blog what basis is. This concept refers to the difference between the spot price of a commodity in the physical market and its price in the futures market.

September 4, 2023

hEDGEpoint Global Markets

In hedge operations, basis plays a significant role as it determines how futures contracts align with spot prices. Futures contracts are standardized financial agreements between two parties to buy or sell an underlying asset at a specified price on a future date.

To better understand, imagine the following scenario: a corn producer wants to protect the value of their crop, which will be harvested in June. To do this, they have the option to sell corn futures contracts to deliver the product this month, thereby fixing the price.

However, if the basis changes by the futures contract’s expiration date, it can affect the hedge. Therefore, it’s essential to understand how to strategically use basis and its associated risks.

How Can Basis Be Used Strategically?

Basis strategies are used in the commodities market to capitalize on or manage variations in the difference between spot and futures prices of a particular product. These tools can be used for protection against basis value fluctuations.

Below, we outline each of these strategies.

Long Basis Strategy: Buying Basis

This approach is used when a trader believes that the spot price of a particular commodity will rise compared to the future price in the coming months.

By implementing the long basis strategy, the trader will take a l     ong (buy) position in the spot market, purchasing contracts for the product in the short term in the local market. Simultaneously, they will take a short (sell) position in futures contracts.

This results in a positive payoff that precisely reflects the difference between the price at which they bought the product in the spot market and subsequently sold it.

Short Basis Strategy: Selling Basis

This approach is applied when a trader believes that the basis of a particular asset in their local market will shift over a certain period. In this case, the spot market price is expected to decrease over time compared to the price of futures contracts for the same commodity.

With this strategy, the trader anticipates a reduction in spot market prices compared to futures, meaning a decrease in basis value. Through the short basis strategy, the trader takes advantage of a stronger basis in the short term. They can sell the asset in the local market at the spot price, anticipating that it will become even cheaper in the coming months. Simultaneously, they buy futures contracts for this asset on the reference exchange.

Basis Risk: What Is It and How Does It Relate to Hedge?

The commodities market is subject to various risks, including price fluctuations influenced by supply and demand factors.

In this context, risks can be minimized through hedge tools, with the use of derivatives such as futures contracts being a prominent choice. With these alternatives, hedgers commit to buying or selling the commodity at a specific price on a predetermined date.

However, hedge operations conducted on the exchange with futures contracts have different patterns than the characteristics of products traded in the physical market. This leads to the basis difference.

Basis fluctuates over time and can be either negative or positive, reflecting whether the spot price of the commodity is lower or higher than the futures market quotation, respectively. This variation in basis over time is called basis risk, a crucial concept as it can impact the final outcome of a hedge.

Practical Example of Applying Basis Risk in Hedge

To fully understand everything we’ve explained, let’s revisit the example from the beginning of the text. Imagine the following situation: in January, a corn producer in Rio Grande do Sul believes that the commodity will have a higher spot price in the physical market by the end of the harvest, around June.

In their view, the basis variation will increase over this period due to a predicted reduced supply and increased demand in their production region, stemming from the possibility of heavy rains that could affect the crop. Consequently, spot market prices for the commodity will be elevated in June.

With this estimation in mind, in January, they decide to buy corn in the spot physical market and store it, expecting to sell it in June at a higher spot price. They also decide to sell futures contracts for the same corn because the initial harvest price is more favorable than the historical average of future corn prices at this time.

At the beginning of the harvest in January, prices stand as follows:

– Spot price in the local physical market: $21.00 per bushel

– Price locked in the futures contract expiring in June: $40.50 per bushel

– Basis: -$19.50

At the end of the harvest in June, prices are as follows:

– Spot price in the local physical market: $25.00 per bushel (an increase of $4.00 per bushel)

– Futures market price: $40.00 per bushel (a decrease of $0.50 compared to the futures contract sale price of $40.50)

– Basis: -$15.00 (increased)

When the harvest is ending, considering the scenario of an increased basis, the trader has:

– A profit of $0.50 compared to the futures market because they sold the corn on the reference exchange for $40.50 in January, a price fixed in the futures contract expiring in June.

– A profit of $4.00 compared to the physical market. This is because they bought the corn for $21.00 per bushel at the beginning of the harvest, so they benefited when the spot market price rose to $25.00 by the end of the harvest. Consequently, they can sell the corn they bought in January at a higher spot price in June.

Summing up the results from the exchange and the physical market, the producer made a gain of $4.50 per bushel, reflecting the increased basis variation. However, if the basis had decreased, they likely would have incurred a loss – this is basis risk in practice.

hEDGEpoint: Hedge Instruments for Your Business

Understanding what basis is, how to use it strategically, and the risks associated with its variation makes a significant difference in hedge operations. This knowledge allows you to protect your business while making informed decisions.

hEDGEpoint operates with in-depth knowledge of the commodities market, combining technology, insights, and data analysis to apply risk management instruments.

Contact a hEDGEpoint professional to learn more!

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