Basis Trading is a strategy used by elevators (and some farmers) looking to take advantage of favorable basis prices by exploiting the difference between the cash and futures. Grain elevators buy and sell grain all year around. When elevators make commitments to buy corn from farmers on the local market, elevators will also sell futures close to the cash delivery date to hedge themselves. When elevators make commitments to sell corn to ethanol plants and other end uses, they will also buy futures with expirations close to the cash delivery date to hedge themselves.
Long the Basis = Long Cash & Short Futures
When some is “long the basis” that means the trader is long the cash and short the futures. Let’s say it is September and a farmer has to sell corn for much needed cash flow to an elevator for November delivery. Cash prices are $4.50 and the December futures are $4.80. The elevator bid is 30 under and the elevator knows that around harvest in their local market the basis is typically the lowest all year.
Current Basis = $4.50 cash – $4.80 Dec Futures = -$0.30 or “30 under Dec”
The farmer agrees to $4.50 and sells the corn to the elevator and the farmer will deliver in November. The elevator agrees to by the corn at $4.50 for November delivery and at the same time sells Dec Futures at $4.80. The elevator has locked in a 30 cents basis. The elevator is also now “Long the Basis”.
Long the Basis = Long Cash & Short Futures
Now that the elevator is long the basis (long cash corn and short futures), they want to see the basis increase from -30 under. They want to see the cash prices gain against the futures price. For this to happen the local market needs to be stronger than the futures market.
Let’s say by November we have seen a huge increase in local ethanol demand and cash corn is now $4.95 and the futures are $4.85. The basis is now +$0.10 (10 over). The elevator has made 40 cents on the basis while the futures markets have only move 5 cents! If the elevator selling cash corn to an ethanol plant for $4.95, they made 45 cents on the cash buy at $4.50 from the farmer. If they buy back the Dec corn futures at $4.85, they lose 5 cents on the original futures sale at $4.80. That is a combined 40 cents they made on trading the basis between local cash and futures prices.
- September: Elevator buys Corn for Nov Delivery at $4.50
- September: Elevator sells Dec Corn futures for $4.80.
- September: Elevator is long the basis from “30 under Dec” ($4.50 – $4.80 = -$0.30 cents)
- November: Elevator sells Corn to Ethanol plant for $4.95 (45 cent gain on cash)
- November: Elevator buys back Dec Corn futures for $4.85 (5 cent loss on futures)
- November: Elevator was long the basis from -$0.30 and exited at +$0.10 for a 40 cent gain.
Please note, if a farmer has storage on farm, they can trade the basis too. Instead of selling their corn to the elevator, they just sell the futures. They have the corn in the bin and they are short futures, therefore they are now basis traders and they are “Long the Basis”. When they want to exit their Basis Trade, they just sell the cash to the Elevator. There is no reason why the farmer could not have made the same 40 cents buy selling Dec Futures in September instead of selling directly to the elevator.
Why is this important? Many areas around the country have times of year when the basis is low and when the basis is high. If you understand your local market, there are times in the year where farmers and elevators may want to be “Long the Basis” (Long Cash, Short Futures) or “Short the Basis” (Short Cash, Long Futures). Basis traders look to be long the basis when their basis is low in their local market and they look to be short the basis when the basis is high in their local markets.
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