What is Basis Trading?
Basis trading is a financial arbitrage trading strategy that involves the trading of a financial instrument, such as a financial derivative or a commodity, with the motive of profiting from the apparent mispricing of the securities. It is also referred to as cash-and-carry trade.
Basis trading is carried out when a trader thinks that the securities they’ve invested in are mispriced. In order to address the gap, traders carry out basis trading to profit from it, avoiding all perceived potential losses in the process.
- Basis trading is a financial arbitrage trading strategy that involves the trading of a financial instrument, such as a financial derivative or a commodity, with the motive of profiting from the apparent mispricing of the securities.
- Basis trading is carried out of the perception or when the trader is of the opinion that the securities that they invested in are mispriced.
- To execute a basis trading transaction, a trader would simply take a long position for the commodity, derivative, or underlying they perceive to be undervalued and opt a short position for the derivative or underlying they perceive to be overvalued.
Basis Trading – Trading Instruments
Basis trading is most common in relation to financial derivatives or commodities that are fluid in trading against one another. They include futures contracts, currency contracts, debt instruments contracts, etc. To execute a basis trading transaction, a trader would simply take a long position for the commodity, derivative, or underlying they perceive to be undervalued and opt a short position for the underlying or derivative they perceive to be overvalued.
However, in order to make a legitimate and substantial profit, the trader often undertakes a generous amount of leverage while opting for long and short positions. It is the most significant risk in basis trading that a trader usually undertakes because the returns are very profitable and favorable. The trade basis is calculated as follows:
1. Long position
A long position in the trading world refers to the purchasing and owning of stocks, commodities, etc. that the trader expects to have favorable trading prospects, i.e., an increase in their value in the future. Opting to take a long position is simply referred to as “long,” and the trader is simply said to be “going long.”
2. Short position
A short position is the exact opposite of a long position. When a trader anticipates a future fall or decline in the price of a security, the trader sells off the security with the intention or idea of repurchasing it at a later lower price. Hence, the trader, upon selling the securities, is “short” of the securities and intends to purchase them at a future lower price.
A Significant Risk of Basis Trading – Leverage
Leverage is simply the use of borrowed financing or borrowed capital to fund the trader’s investments. It is most often used as an investment strategy that involves the use of borrowed capital (includes various kinds of financial instruments) with an aim of increasing the potential return from the investment.
While there is a high risk associated with such a method of financing investments, it is also a very fruitful and profitable one if used correctly. It is why traders undertake the risk, specifically when anticipating an advantageous return in the end. Taking a short position using leverage comes with unlimited downside risk because the price of the asset lacks an upper bound.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: