What Is a Wide Basis?
A wide basis is a common condition in futures markets where the local cash (spot) price of a commodity differs significantly from its futures price. This situation contrasts with a narrow basis, where the spot and futures prices are closely aligned.
Normal discrepancies between spot and futures prices typically arise from factors such as transportation and holding costs, varying interest rates, and unpredictable weather. Known collectively as the basis, these differences tend to converge as the expiration date of the futures contract approaches.
Key Takeaways
- A wide basis signals a substantial gap between spot and futures prices.
- It might indicate market illiquidity or increased carrying costs.
- Basis narrows as the futures contract nears expiration—providing avenues for potential arbitrage profits.
Understanding Wide Basis
Essentially, a wide basis reflects an imbalance in supply and demand. For instance, local cash prices might soar relative to futures prices if short-term supply plummets due to poor weather conditions. Conversely, a bumper harvest could depress local cash prices compared to futures prices, leading to a wide basis.
This gap, defined as the local cash price minus the futures contract price, should decrease as the futures contracts approach their expiration. Otherwise, arbitrage opportunities could arise for investors looking to exploit the price differences.
If the basis shrinks from -$1 to -$0.50, it’s termed as a ’tightening basis.’ Conversely, if it reduces from a larger positive to a smaller positive figure, it’s called a ‘softening basis.’
Important
A narrow basis signifies a highly liquid and efficient marketplace whereas a wide basis indicates relative illiquidity and inefficiency. Nonetheless, some variation between local cash and futures prices is normal.
Real World Example of a Wide Basis
Imagine you’re a commodities futures trader eyeing the oil market. The local cash price for crude oil stands at $40.71, while crude oil futures maturing in two months are priced at $40.93. In this scenario, the basis is narrow at -$0.22 (spot price of $40.71 minus futures price of $40.93). Given the high volume of trade and the short time until contract expiration, this narrow basis makes sense.
However, looking further into the future, wider basis values appear. For instance, a contract for delivery in nine months might show a futures price of $42.41, creating a wider spread of -$1.70. This discrepancy could be attributed to expectations of decreased supply or increased economic activity. Regardless, the basis will likely decrease as the contract date nears.
Related Terms: narrow basis, spot price, futures price, holding costs, expiration date.
