Long the Basis
Being long the basis means holding a long position in the physical (spot) commodity or asset and a short position in the corresponding futures contract, profiting when the spot price rises relative to the futures price (i.e., when the basis strengthens or becomes less negative). It is the basis trading strategy of a hedger who owns the physical commodity and sells futures to protect against price declines.
Key takeaways
- The basis is defined as: Basis = Spot Price − Futures Price; for most physical commodities futures, the futures price is above the spot price (negative basis or contango) due to storage and financing costs.
- A 'long the basis' position profits when the basis strengthens (becomes less negative or more positive): the spot price rises relative to the futures price, or the futures price falls faster than the spot price.
- Convergence at expiration is a fundamental property of futures markets: spot and futures prices converge as the delivery date approaches, ensuring that a long-the-basis position held to delivery has zero basis at settlement.
- Basis risk—the uncertainty about the basis at the time a hedge is lifted—is the residual risk in any hedged position; sophisticated hedgers monitor and actively manage their basis exposure.
- Roll yield in commodity investing arises from changes in the basis over time: a positive roll yield occurs when the market is in backwardation (spot > futures), benefiting long futures holders.
Explanation
Basis trading is a sophisticated overlay to the fundamental hedge or arbitrage strategy in commodity and fixed income markets. The basis (spot price minus futures price) embeds information about cost of carry—primarily storage costs, financing rates, convenience yield, and quality differentials. Understanding basis dynamics is essential for any market participant involved in physical commodities, commodity futures, or Treasury bond futures.
The cost-of-carry model predicts the theoretical relationship between spot and futures prices: F = S × e^{(r + s − y)T}, where r is the risk-free rate, s is the storage cost, y is the convenience yield (the flow benefit of holding the physical commodity), and T is time to expiration. This implies a basis of S − F = S × (1 − e^{(r + s − y)T}). For commodities where storage costs and financing rates dominate (grains, metals, energy), futures prices typically exceed spot prices (negative basis, or contango). For commodities where convenience yield is high (oil during supply disruptions), spot prices can exceed futures (positive basis, or backwardation).
A party that is long the basis—holding physical inventory while short futures—profits in two scenarios: when the basis strengthens from below-normal levels back to fair value (a mean-reversion trade), or when the market moves from contango to backwardation due to a supply shock or demand surge that makes nearby physical delivery more valuable than deferred delivery. Grain elevators in the Midwest routinely adopt long-the-basis positions: they buy grain from farmers (going long physical), sell futures contracts as a hedge (going short futures), and profit from the narrowing of the basis as the futures contract approaches expiration and spot-futures convergence occurs.
In fixed income markets, the concept of 'long the basis' applies to Treasury bond basis trading: buying a specific Treasury bond (the cash security) and selling Treasury bond futures against it. The basis here reflects the cost of carry adjusted for the cheapest-to-deliver (CTD) option value embedded in Treasury futures. Hedge funds active in this space analyze which security is CTD, model the value of the delivery options, and establish long-the-basis positions when the market undervalues the CTD bond relative to the futures price.
Basis risk—the uncertainty about what the basis will be when a hedge is ultimately lifted—cannot be completely eliminated even with a well-constructed hedge. This risk is distinct from outright price risk and requires separate attention. Over time, cross-sectional variation in basis behavior (for example, different basis levels across different delivery locations for crude oil—Cushing, Brent, WTI) creates trading opportunities and hedging complexities. Hedgers must choose which futures contract to use as their hedge instrument and accept the residual basis risk of that choice.
Formula
Basis = Spot Price − Futures Price; Basis P&L = (Basis at Close-Out) − (Basis at Entry)
Example
A grain elevator in Central Illinois buys 100,000 bushels of corn from local farmers in October at a spot price of $4.50/bushel and simultaneously sells 20 December CBOT corn futures contracts at $4.70/bushel (the basis is thus −$0.20/bushel, i.e., spot − futures = $4.50 − $4.70). The elevator is now long the basis. By December (delivery month), the spot price has risen to $4.90 and the December futures price has risen to $4.95 (basis is now −$0.05/bushel). The elevator sells the corn in the spot market at $4.90 and buys back its futures at $4.95. Spot market profit = $4.90 − $4.50 = +$0.40/bushel. Futures loss = $4.95 − $4.70 = −$0.25/bushel. Net result = +$0.15/bushel, versus the original basis of −$0.20/bushel. The basis has strengthened (from −$0.20 to −$0.05), generating a net positive contribution of $0.15/bushel × 100,000 bushels = $15,000 from the basis position, in addition to the elevator's storage and handling fee income.
Related terms
Arbitrage Backwardation Basis Basis Risk Bond Cheapest To Deliver Contango Convergence Correlation Cost Of Carry Delivery Futures Contract