What does short the base mean?
Short the basis refers to the simultaneous purchase of a futures contract and the sale of the underlying asset in the spot market to hedge against future price increases.
A short base can be contrasted with a long base.
The central theses
- Short Basis is a trading strategy that involves buying a futures contract and simultaneously selling the underlying asset in the cash market.
- Shorting the basis is a directional hedge that fixes a price, effectively eliminating the impact of asset price fluctuations until the futures contract expires.
- A long hedger prefers to narrow the basis when shorting the basis.
Briefly understand the basics
Basis risk is the fluctuation between the spot price of a deliverable commodity and the price of that commodity’s futures contract with the shortest time to maturity. It is unavoidable if an investor wishes to hedge their exposure to adverse price volatility, although it can be mitigated to some extent. This is essentially the goal of long hedgers when they “short the basis”.
Unlike a short hedge, shorting the basis implies that the investor is taking a short position in the commodity and a long position in the futures contract. The commercial hedger employs this futures strategy to hedge a future cash price, thereby removing the uncertainty of rising prices that would affect their future obligation to supply the underlying commodity. This type of hedger wants a base tightening as this reduces the effective spot price for buying that commodity at a later date.
The advantage of the short the basis strategy is that the price is fixed so that a rise in the commodity price at a later date does not affect the trader. For example, a manufacturer that uses cotton as a raw material assumes that it will need a certain amount at a defined point in time in the future. The cotton spot or spot price is $3.50 and the fixed futures contract price is $2.20. To protect against the price increase when it needs to buy the cotton, the manufacturer buys the cotton futures contract at $2.20.
Futures prices reflect the price of the underlying physical commodity. Many futures have a physical delivery mechanism. Therefore, a buyer of a futures contract has the right to stand for delivery of the commodity and a seller must be willing to deliver a short position that is held during the delivery period. However, most futures contracts are liquidated prior to delivery. Only a few go through the actual delivery process. Successful futures contracts depend on convergence, the process by which futures prices converge with physical prices at the futures contract’s expiration date.
Short the basis vs. long the basis
Base trading is a strategy used by elevators (and some farmers) who want to take advantage of favorable base differences by exploiting the difference between spot and forward prices. Grain Elevators buy and sell grain year-round. When elevators make commitments to buy corn from farmers in the local market, elevators also sell futures just before the cash delivery date to hedge. When elevators make commitments to sell corn to a buyer, they also buy futures contracts with expiration dates near the cash delivery date to hedge.
A bullish investor looking to hedge their position would be considered a long basis; A bearish investor looking to hedge would view the basis as short.
Many areas across the country have seasons when base is low and base is high. If you understand your local market, there are times in the year when farmers and elevators want to be “long the basis” (long cash, short futures) or “short the basis” (short cash, long futures). Basis traders go long the basis when their basis is low in their local market and short the basis when their basis is high in their local market.
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