Derivatives trading is one of the most sought-after trading techniques that allow investors to diversify and earn profits. A derivative is commodity, a currency, or even an index. The buyer is obligated to buy, or the seller is obligated to sell the underlying asset at a specified price on a specified date in the future.
Derivative investors trade using two contracts called Futures and Options.
Futures Contract: A Futures Contract is an agreement between the buyer and the seller of a particular asset. The buyers purchase a specific quantity of the asset at a predetermined price payable at a specific time in the future. This contract remains until maturity, and investors can sell them if the price has risen at the time of the expiry to make a profit.
Options Contract: An options trading contract is generally permitted in top assets wherein the trader has the right but not a legal obligation to buy/sell the purchased security at a fixed price. Such a contract helps investors make a profit based on price fluctuations without having to buy/sell the contract.
Investors who prefer Futures contracts choose various trading strategies to manage their investments and ensure their trades are profitable. One such strategy is Basis Trading.
Basis in Derivatives: What does it mean?
The basis in derivatives is the difference between the spot price (current price) and the strike price (predefined price) of the futures contract. Basis in futures contracts works on the principle of price fluctuation of the underlying asset and how it is priced in its futures contract against its current price.
If an investor thinks that this basis in derivatives will increase, they initiate a trade called ‘Long the basis’. However, if they think the basis will decrease, their trade is called ‘Short the basis’. Basis in the futures market is a common trading strategy for manufacturers or producers to hedge the cost of production and mitigate the losses against the anticipated sale of their produced commodity.
How do you find the basis of a derivative?
Let’s consider the following example to understand the process of finding a basis in derivatives:
Suppose a farmer produces wheat and is expecting to deliver his whole production after three months. However, he fears that wheat prices may go down due to good weather conditions and the oversupply of wheat. The farmer creates numerous futures contracts to cover the sale of his complete produce.
If the spot price of wheat per quintal is Rs 2000 and the farmer sees that a futures contract for the same commodity was priced at Rs 2500, which expired two months back, the farmer can now lock in a price on a +500 basis. The trade is called ‘Short the basis’ as the farmer expects the futures contract price to fall.
Conclusion
Derivatives are a complex asset class that demands detailed knowledge and high-risk exposure from a trader. When trading in derivatives, investors must know what the basis of derivatives is to understand their effects on the price movement and subsequent profits. For further assistance on derivatives trading, you can consult financial advisors at IIFL and make informed decisions based on extensive financial reports and detailed market analyses.
