What is basis trading in the stock market?

What is basis?

In the stock market, the term "basis" refers to the difference between the cash price of a security and its futures price. It reflects the cost of carrying the asset from the spot market to the futures market, taking into account factors such as interest rates, dividends, storage costs, and other expenses.

What is Basis Trading?

Basis trading is a trading strategy that capitalises on the price differential between the cash (spot) market and the futures market for the same underlying asset. Traders seek to profit from changes in the basis by taking offsetting positions in the cash and futures markets. This strategy involves buying or selling the underlying asset in one market while simultaneously taking an opposite position in the futures market to exploit perceived mispricing or inefficiencies.

Example of Basis Trading

Suppose the cash price of a stock is Rs. 1000, and the futures price for the same stock is Rs. 1010. This Rs. 10 difference between the cash and futures prices represents the basis. In basis trading, an investor might sell short the stock in the cash market at Rs. 1000 and simultaneously buy the futures contract at Rs. 1010. If the basis narrows or widens over time, the trader can profit by closing out their positions at the opportune moment, exploiting discrepancies between the cash and futures prices.