The concept of basis in futures markets is closely connected to basis risk. Basis risk arises from the difference between the spot price of the underline asset and the price of a certain future contract. It can affect the positions of hedgers, speculators and arbitrageurs both positively or negatively depending on market circumstances and the trade being taken.

Basis risk examples in speculative trading

Suppose that we are opening a long position in WTI crude oil futures with delivery date after one year and price $105/barrel. The spot price of WTI crude oil the time we are opening the position is $100/barrel, so we have a negative basis (spot – future price) equal to -$5/barrel. Suppose now that after one year, on the last trading day the spot price of WTI crude oil is at $102/barrel. The contract price due to the convergence of spot and futures prices as we are approaching expiration, will have declined by $3/barrel in order to coincide with the spot price (from $105/barrel to $102). On the last trading day the basis will be of course zero (spot – future price = 0). In this example although the spot price has risen $2 from the first day we opened the position, we find ourselves losing $3/barrel due to basis risk.

Now assume that on the above example the spot price of WTI oil when we opened the position wasn’t $100 but $110/barrel. So, here we have a positive basis equal to +$5/barrel. Suppose also that after one year, on the last trading day the spot price of WTI crude oil is at $108/barrel. The contract price due to the convergence of spot and futures prices as we are approaching expiration, will have advanced by $3/barrel in order to coincide with the spot price (from $105/barrel to $108). On the last trading day the basis will be of course zero (spot – future price = 0). In this example although the spot price has fallen $2 from the first day we opened the position, we find ourselves profiting $3/barrel due to basis.