Futures Basis

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Basis

What Does Basis Mean?

Although the term “basis” holds various meanings in finance, it most frequently refers to the difference between the prices and the expenses involved in transactions when calculating taxes. Such usage relates to the broader terms “cost basis” or “tax basis” and is specifically used when capital gains or losses are calculated for income tax filings.

Key Takeaways

  • In finance, basis is generally used to refer to the expenses or total costs of an investment.
  • It can also be used to refer to the difference between the spot price of an asset and its corresponding derivative futures contract.
  • Basis has important tax implications because it represents the costs associated with a product.

In another context, basis refers to the variation between the spot price of a deliverable commodity and the relative price of the futures contract. Basis may also be used in reference to securities transactions. Simply put, a security’s basis is its purchase price after commissions or other expenses.

Note: To better understand the term “basis” in all of its different contexts, this article provides examples below.

Basis in the Futures Market

In the futures market, basis represents the difference between the cash price of the commodity and the futures price of that commodity. It is a critically important concept for portfolio managers and traders to grasp because the relationship between cash and futures prices affects the value of the contracts used in hedging. But the concept is also fuzzy at times, because there are gaps between spot and relative price until expiry of the nearest contract, therefore the basis is not necessarily accurate.

In addition to the deviations created because of the time gap between expiry of the futures contract and the spot commodity, there may be other variations due to actuals, different levels of product quality, and delivery locations. In general, the basis is used by investors to gauge the profitability of delivery of cash or the actual and is also used to search for arbitrage opportunities.

Basis as Cost

A security’s basis is the purchase price after commissions or other expenses. It is also known as cost basis or tax basis. This figure is used to calculate capital gains or losses when a security is sold. For example, let’s assume you purchase 1,000 shares of a stock for $7 per share. Your cost basis is equal to the total purchase price, or $7,000.

In the context of IRAs, basis originates from nondeductible IRA contributions and rollover of after-tax amounts. Earnings on these amounts are tax-deferred, similar to earnings on deductible contributions and rollover of pre-tax amounts. Distributions of amounts representing basis in an IRA are tax-free. However, to ensure that this tax-free treatment is realized, the taxpayer must file IRS Form 8606 for any year that basis is added to the IRA and for any year that distributions are made from any of the individual’s traditional, SEP and/or SIMPLE IRAs.

Failure to file Form 8606 may result in double taxation of these amounts and an IRS-assessed penalty of $50. For example, let’s assume your IRA is worth $100,000, of which $20,000 was nondeductible contributions, which accounts for 20% of the total. This ratio of basis applies to withdrawals, so if you withdraw $40,000, 20% is considered basis and is not taxed, which calculates to $8,000.

Futures Basis

The basis reflects the relationship between cash price and futures price. (In futures trading, the term “cash” refers to the underlying product). The basis is obtained by subtracting the futures price from the cash price.

The basis can be a positive or negative number. A positive basis is said to be “over” as the cash price is higher than the futures price. A negative basis is said to be “under” as the cash price is lower than the futures price.

Basis Calculation Example
Spot (Cash) Price $42
August Futures Price $47
Basis -5 (In market lingo, the basis is “$5 under August”.)

Strong or Weak Basis

The basis changes from time to time. If the basis gains in value (say from -4 to -1), we say the basis has strengthened. On the other hand, if basis drops in value (say from 8 to 2), we say the basis has weakened.

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Short term demand and supply situations are generally the main factors responsible for the change in the basis. If demand is strong and the available supply small, cash prices could rise relative to futures price, causing the basis to strengthen. On the other hand, if the demand is weak and a large supply is available, cash prices could fall relative to the futures price, causing the basis to weaken.

However, although the basis can and does fluctuate, it is still generally less volatile than either the cash or futures price.

Basis Risk

Basis risk is the chance that the basis will have strengthened or weakened from the time the hedge is implemented to the time when the hedge is removed. Hedgers are exposed to basis risk and are said to have a position in the basis.

Long Basis Position

A long basis position stand to gain from a strengthening basis. Short hedges have a long basis position.

Short Basis Position

A short basis position stand to gain from a weakening basis. Long hedges have a short basis position.

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In U.S. Treasury futures, the basis is the price spread, usually quoted in units of 1/32, between the futures contract and one of its eligible delivery securities.

This example will show how basis is determined and will help to consider what market action might do the level of the spread or basis.

Starting with the list of U.S. Treasury securities eligible for delivery into a quarterly U.S. Treasury futures contract, the list could range from relatively small (three issues versus the Ultra Ten-Year contract) to many (18 issues versus the Ultra Bond contract). Each eligible security has its own conversion factor for the respective quarterly futures contract it is eligible for. The conversion factors are set based on the pricing to the first business day of the quarterly contract month and are fixed for the life of that contract month. The variable inputs to the basis are therefore the price of the futures contract and the price of the security being considered, both subject to changing market conditions.

What is Basis?

Basis can be defined as the difference between the clean price of the cash security minus the converted futures price.

Basis = Cash Price – (Futures Price x Conversion Factor)

For example, consider a cash 5-year note, the 1.75% of November 30, 2021 versus the March 2020 5-year U.S. Treasury futures contract (FVH7).

Assume the price of the cash security to be 99-10+ (1/32), the price of FVH7 to be 117-18+ (1/32), and the conversion factor (CF) of the cash security versus March 2020 5-year futures to be 0.8292. Because U.S. Treasury cash and futures products trade in full points and fractions of a 1/32 we must first convert our futures and cash prices to decimal then perform the math, then convert back to 1/32 form.

Step One: Convert prices from 1/32 to decimal

Pfutures = 117-18+ (1/32s) = 117.578125

CF = 0.8292, Pfutures = (117.578125 x 0.8292) = 97.49578125

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