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John Naronha

What is basis and spread?

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Basis is the difference between the spot and the futures prices of the same underlying security. There is a definite relationship between spot and futures although there can be temporary price gaps due to the sudden variation in the demand and supply stats between the two, and which can remain until the expiry of the futures contract. While basis is not necessarily accurate, they are used to calculate the profitability of delivery of cash or the actual and is also used to examine arbitrage opportunities. Basis is calculated using the formula:

B= F- S

F= future price

S= spot price

Example: If the spot price of crude oil is $60 per barrel and the three-month futures is $65, the basis is $5.

Basis risk:

It is the financial risk in a hedging strategy where offsetting investments in the same underlying may not experience predicted price changes in conflicting directions. This imperfect correlation between the two investments can lead to excess gains or losses in a hedging strategy, thereby increasing the risk to the strategy.

Example: If you’re attempting to hedge a two-year bond by purchasing T-bill futures, the risk would arise when the yield on the two financial instruments do not rise or fall proportionately.

To calculate the precise value of basis risk, an investor has to have access to the current price of the underlying asset and its futures price.

Example: If the price of crude oil is $60 per barrel and the futures contract used to hedge this position is trading at $59.98, the basis is -$0.02. If an investor is trading in large volumes, the gains or losses from basis risk can be significant.

 

Spread trading broadly comprises of simultaneously going long and short in two futures contracts to profit from the price discrepancy between the two. In short, spread trading typically involves holding offsetting positions in two futures contracts either in the same or an alternative underlying with or without the same expiration dates. It is not unusual to carry out spread trading between asset classes within the same industry such as Amazon and Walmart, between two Exchange Traded Funds (ETF’s) or two diverse asset classes such as equities and the Stock Index. Spread trading can be categorized into

Intra-market spreads-

Intra-market spreads are also called calendar spreads. The strategy involves a combination of a long and short futures position in the same underlying security, but with different expiration dates.

Example: Long Gold June futures and short Gold August futures.

Intermarket spreads-

Inter-market spreads are a combination of a long futures position in one security and a simultaneous short futures position in another security with the same expiration date. If the securities have different expiries, they will be called intra-market or calendar spreads.

Example: A long trade in Gold December futures on the Commodity Exchange (COMEX) and a corresponding short position in Silver December futures on the same exchange.

Inter-exchange spreads-

Inter-market spreads are a combination of a long futures position on one exchange and a simultaneous short futures position on another exchange in the same underlying security. Inter-exchange spreads can comprise of the same expiration dates or calendar spreads.

Example: A long trade in Gold June futures on the COMEX and a corresponding short Gold June futures on the Multi Commodity Exchange (MCX).

 

If you’re a fixed-income trader interested in spread trading, you can take a look at some of the prominent strategies highlighted below-

Yield spreads –

Also known as credit spreads, yield spreads derive the difference in the yield between two bonds with varying credit quality. For instance, if one bond is yielding 7 percent and another bond is yielding 4 percent, the spread is 3 percentage points or 300 basis points.

Option-Adjusted spread-

To discount a security's price and match it to the current market price, the yield spread must be added to a benchmark yield curve. This adjusted price is called option-adjusted spread and is typically used for mortgage-backed securities, bonds, interest rate derivatives, and options.

For instance, if you have two mortgage-backed securities with the same maturity, the one with the higher option-adjusted spread will be selling at a lower price and would be considered a bargain compared to the alternate mortgaged backed security.

Z- spread:

It is also called Z SPRD, yield curve spread or the zero volatility spread of a mortgage-backed security is the spread over a zero coupon treasury yield curve which is required to discount a pre-defined cash flow agenda to arrive at the current market price. This kind of spread is extensively used in the credit default swap (CDS) markets to calculate credit spreads since they are mostly insensitive to corporate and Government bonds.

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Basis represents the difference between spot and futures values of the same asset. While spot prices are paid instantly, futures contracts retain payments to a set future date. 
Considered an arbitrage technique, a basis trade aims at gaining from the variable pricing of connected futures contracts. Opposite positions are taken from two or more matching contracts to conduct a trade. That way, the markets approach the equilibrium as the pricing variations are adjusted to make profits. The fact that earnings come from slight price movements calls for high leverages. Aside from commodities, such trades may involve equity indices, currencies, and contracts backed by debt instruments. 
In contrast, spread trading entails maintaining offsetting stands in two futures agreements. It targets profits resulting from pricing instabilities facing contracts with unique or common expiration. Spread trading may occur between assets in the same industry like Alibaba and Amazon, ETFs, or separate asset classes, for example, equities and stock indexes. A spread trader not only benefits from tight risk controls but also standardized order-entry.
 

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Hello John,

Thanks for coming here.

Basis is the variation between an asset’s spot and futures contract prices. As such, basis trading entails buying a security and unloading a futures contract with a matching underlying security. According to the trader, both securities are mispriced and a profit depends on the contract’s expiration or market correction in the short term.
Conversely, a spread shows the price difference between two matching securities. It features two legs presented concurrently as a unit. As opposed to profiting from the direct change of leg values, the spectator relies on the shrinking or broadening of the spread. 
Spreads fall into two categories. For intra-market spreads, the assets share a market but vary in their maturity dates. On the contrary, inter-market spreads are characterized by separate assets that are highly related. An example is selling a soybean oil contract in July and buying soybean meal futures the same month.
 

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