How to Use Basis in Hedging

Cash Price - Futures Price = Basis (at a specific point in time)

A producer's decision as to when and how to market their crops or livestock can have as big an impact on their net bottom line profit as any production decision they may make throughout the year. Farmers today have more marketing alternatives than in the past and face a complex and fast paced marketing system. They need to compare the traditional marketing methods of making cash sales at harvest (or before harvest, on guaranteed insured bushels), or when livestock are ready for market, to forward contracting or hedging with futures or options. To do this they need to thoroughly understand the relationship between different quotes in prices, to be able to compare them equally in terms of time, place and the quality.

As stated above the relationship between the cash and futures price is known as the "basis". In marketing, basis generally refers to the difference between a price in a particular cash market and a specific futures contract price. Basis "localizes" the futures price with respect to location, time, and quality. Understanding basis makes it possible to compare the "futures market price quotes" with cash and "forward contract" price quotes.

Calculating Basis

The formula for calculating basis is: Cash Price - Futures Price = Basis at a specific point in time. A negative basis implies the futures price is greater than the cash price, and a positive basis implies that the futures price is less than the cash price.

In this formula, the "cash price" is for a specific location, time, and quality of product. The location may be a specific elevator, ethanol plant, packer, etc., or it may represent an average price for the general area. The time may represent a specific day or possibly a weekly average. Quality may be what grade or corn you have or the weight of your cattle. The "futures price" in the formula is for a contract for the same time the cash price represents. The quality of the product in the futures contract price is standardized.

Basis is most often calculated as the difference between the cash price and the closest to expiration (nearby), futures contract. For example, in June the corn basis would be calculated using the current cash price minus the July futures contract price. Basis with grains may also be calculated using the cash price and a more distant futures contract in order to see if the market is offering returns to storage ("Carry").

Livestock is different in that you would only consider the nearby basis (not deferred), for hedging and cash sale purpose because, unlike grains, livestock are perishable and cannot be stored for any length of time, like grains can.

In our next installment we will discuss ways to "predict basis", and ways you can start to track and record basis data in your area properly.

Article Source: Source