The Concept of Basis in Commodity Futures

Basis Defined

The difference between the local spot price (cash price) and the relevant futures price of a commodity is called the commodity basis.

Basis = Spot price - Futures price

For example, if the spot landed price of gold in March is Rs. 9450/10gm and the April gold futures price is Rs. 9400/10gm, then the basis is Rs. 50/10gm (9450-9400). The basis can be positive or negative.

The spot price of a commodity is the prevailing cash price in the market. The futures price is a representation of the market opinion of the spot price of the commodity on some future date. Theoretically, the futures price and the spot price are related in the following manner

Futures price = Spot price + Cost of carry

The cost of carry is the cost of carrying the commodity from the current month to the month of delivery. This includes costs of storage, insurance, interest etc. Thus usually, the price of a futures contract is higher than the prevailing spot price. This condition is known as Contango.

The actual difference between the spot and the futures price may be different from the cost of carry and can vary based on the demand and supply of the underlying commodity at current and expected levels in the future. Thus it is possible for the futures price to be less than the spot price. This condition is called Backwardation. For e.g. the copper futures on NYMEX have mostly been in backwardation since the 1950's.

Whether the market is in Contango or Backwardation, as the futures contract approaches the expiry date, the spot and future prices converge.

Spot Price <
Futures Price
Basis Market Condition
Negative Contango or Normal

Spot Price <
Futures Price
Basis Market Condition
Positive Backwardation or Abnormal

The basis depends on the local spot market price and so it reflects the local market conditions. It is affected by the following factors:

Local supply and demand.

Storage costs.

Profit margins.

Basis is usually a negative number because of carrying charges. In normal market conditions, cash prices are lower than the nearby futures prices. With the approach of delivery on the futures, carrying charges diminish and the price difference between cash and futures will decrease.

It is important to understand Commodity Futures Basis, Spot Price, Futures Price and the relation between Weakening Basis and Strengthening Basis as these are the key metrics that will help you to take better Commodity Trading Decisions.

In the next chapter we will learn about the changes in commodities basis and what causes the strengthening and weakening basis in the market.

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