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We saw earlier that basis (B) is the difference between the SP and the FP of the underlying asset:
B = SP - FP (note that B is often also calculated as B = FP - SP).
Basis trading in the futures market is a trading tactic consisting usually of the purchase of a security and the sale of a futures contract with the same underlying security. The motivation is that the speculator / arbitrageur is of the opinion that the two securities are mispriced with respect to each other, and that the mispricing will correct itself at some stage in the near future, or that a profit will occur upon expiry of the contract.
The best example of a successful basis-trade is where the spot purchase price of a share (SP) plus the cost of carry (CC) (remember, SP + CC = FVP) is less than the futures price (FP) (i.e. the basis number is larger than the CC). The (almost) risk-free profit will be evident in this case: the speculator / arbitrageur will (1) buy the share (at the SP), have it carried in the market at the CC until expiry (remember, SP + CC = FVP), (2) sell the corresponding futures contract. In effect, the overvalued security (the future) is sold and the correctly priced security is purchased. This trade is also called cash-and-carry trade.
A spread is the difference between the prices of two similar or related securities (here regarded as futures contracts), and a spread trade has two legs, usually executed simultaneously as a unit (to avoid execution aka leg risk): the purchase of one security and sale of a similar or related security. The result is a spread (a value), and the motivation is an expected change (narrowing or widening) in the spread over time.
It will be evident that the speculator / arbitrageur hopes to profit not from the changes in the prices of the legs directly, but from the narrowing or widening of the spread. Also clear is that the volatility in the spread will be lower than that of the legs, thus lowering risk, but also lowering the potential profit. This is reflected lower margin requirements.
There are two categories of spreads: intra-market spreads and inter-market spreads. The former is where a spread trade is undertaken in the same market but in different maturities of contracts, for example: the sale of a June contract on Share A, and the purchase of a December contract on Share A. An intra-market spread is also referred to as a calendar spread. In the commodity futures market, intra-market spreads are referred to as intra-commodity spreads. An example of the latter follows (one contract = 100 tons) in Table 9.
Table 9: Example of spread trade
The prices of both futures increased, but the nearby contract by more than the distant one. The spread started off at LCC 200 and increased to LCC 300: by LCC 100. The speculator / arbitrageur makes a profit of LCC 100 x 100 tons = LCC 10 000.
The example above is an example of selling the spread: sale of distant contract and purchase of nearby contract. Buying the spread is the opposite: sale of nearby contract and purchase of distant contract.
An inter-market spread is where a trade is undertaken in different but related assets, for example the sale of a June soybean contract and the purchase of a June wheat contract. Another example is the purchase of a September GBP deposit future and the sale of a September Eurodollar deposit future. In the case of commodities, inter-market spreads are also referred to as inter-commodity spreads. Intra- and inter-commodity spreads are sometimes called commodity product spreads.
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