Basis Definition: – A commodity basis is the main difference between the LSP cash price (local spot price), and the associated futures price of a commodities is called.
Basis = Spot price (SP) – Futures price (FP).
If the spot price for the gold in March is Rs. 9450/10gm, and the Apr futures gold price is Rs. 9450/10gm and the Apr gold futures price is Rs. 50/10gm (9450-9400). You can choose to base your decision on a positive or negative basis.
Basis Market Condition
Spot Price Futures price: Negative contango or Normal
Spot Price Futures price: Positive Backwardation, or bnormal
Spot price (SP) is the most popular market cash price for a commodity. The futures price (FP), which is the opinion of the market on the SP of the commodity at a specific date, is the futures price. Theoretically the FP is related to the SP in the following manner.
FP = SP + Cost to carry
The cost of carrying is the cost of the commodity that was used to transport the product from the current month until the delivery month. This includes costs for storage, interest, and insurance. So often, the cost of future agreements or contracts is higher than the SP. This is called the Contango.
The actual difference between the SP & FP could be different from the cost to carry. It can also vary based on future supply & demand for the basic commodity. It is possible for the FP to be less than the SP. This is known as Backwardation. For example, The NYMEX Copper futures have been in backwardation for most of the time since the 1950’s.
Regardless of whether the market is in Backwardation, Contango or both, as the final date approaches, the SP and FP converge.
The basis is largely dependent on the spot market cost, and it therefore reflects the market conditions. These are not likely to affect it:
- Local supply and local demand
- Storage costs.
- Profit margins
Because of the carrying charges, basis is often a negative number. Common market conditions mean that cash prices are lower than nearby futures prices. The delivery of futures is a possibility, so carrying costs will drop and the cost difference between cash and futures will shrink.
Understanding the FP Commodity Futures Basis and SP is crucial. These are the key metrics that will help you make better Commodity Trading Decisions.