Financial derivatives like futures contracts have transformed the way we trade physical commodities like oil, gold, and agricultural products. However, they also introduced a new form of risk, what we call basis risk.
Investors have been encountering this type of risk when hedging against other risks, showing that in trading, there is no ideal method that guarantees the complete mitigation of potential losses.
Traders who gain exposure to commodities through futures contracts or prefer to trade contracts for difference (CFDs) on specialized platforms like the one in this link should understand how spot and derivatives prices behave and what may happen when their movements diverge. They are even more vulnerable because the use of high leverage amplifies potential losses.
You’re about to learn what basis risk is and its effect on commodity trading and how to reduce its impact, but before that, let’s set the right context first by discussing hedging.
What Is Hedging In Commodity Trading
Investors use hedging to reduce the impact of potential losses by taking a second position in the opposite direction. The logic behind this is that the second position can offset losses from the initial position. The goal of hedging is to reduce risk instead of maximizing profits, and it’s often used by businesses dealing with physical commodities, helping them protect against unfavorable price outcomes.
In commodity trading, hedging works much more like an insurance policy and is especially useful for agricultural products and energy instruments, whose prices can be influenced by weather or geopolitical events.
Financial derivatives like futures contracts can be used for hedging by locking in prices. For example, imagine a wheat farmer who wants to sell the harvest three months from now. If wheat prices decline during these three months, he may have no choice but to sell at a lower price. To hedge this risk, he can sell wheat futures today. If wheat prices drop, he will get less for the physical wheat, but his short futures position would generate a profit that offsets that loss either partially or entirely.
How Basis Risk Shows Up in Hedging
Basis risk happens because the spot price and the futures price are always moving in tandem, making things much more complicated for hedging.
The basis is simply the difference between the spot and futures prices. Therefore, it can be either negative or positive.
If wheat currently trades at $700 per bushel in the spot market and a futures contract trades at $710, the basis is -$10.
Now here is how basis risk and its effect on commodity trading shows up. Suppose a farmer sells futures to hedge against declining wheat prices, as in the example above. By the time the wheat is sold, its spot price has dropped to $650, representing a $60 loss per bushel. However, the futures price falls only to $680, meaning the hedge generates a $30 gain.
As you can see, the futures contract doesn’t completely offset the $60 decline, covering only half of it. This is because the basis changed from -$10 to -$30. So, basis risk and its effect on commodity trading arise from unexpected changes in the relationship between spot and futures prices.
And sometimes it may reach the extreme. For example, in April 2020, WTI crude futures briefly traded at a negative price – something almost no hedging model had accounted for. It’s still cited today as the textbook case of basis dislocation, detailed further by Ryan O’Connell, CFA, where even a perfectly sized hedge can leave residual risk on the table.
Types of Basis Risk
There are several types of basis risk, mainly defined by the conditions affecting physical commodities. The most common ones include:
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Location Basis Risk:
Commodity prices can differ between regions due to local supply and demand, weather, infrastructure issues, or transportation costs. If we continue with our example, the wheat price may not move exactly like the futures contract, which is usually standardized. The same issue may happen if a company chooses between WTI and Brent futures for oil price hedging.
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Quality Basis Risk:
Many physical commodities differ in quality, especially when it comes to agricultural products. The price of the particular wheat or coffee being hedged may behave differently because of its better or worse quality compared to the grade represented by the futures contract.
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Calendar Basis Risk:
The timing of the physical transaction may not correspond exactly with the expiration date of an available futures contract.
Managing Basis Risk
Basis risk cannot always be eliminated for good, but traders and businesses can at least reduce it. The most important step is to pick a hedging instrument that tracks the underlying physical commodity as closely as possible.
For example, a business dealing with jet fuel would hedge with heating oil instead of crude given the higher price correlation, even though crude is more liquid.
Ideally, the futures contract corresponds as closely as possible to the physical asset’s quality and location.
It’s also important to ensure that expiration dates match. For example, picking a futures contract whose expiration is close to the expected physical transaction can minimize timing differences.
Traders should therefore monitor not only the prices of commodities and their futures contracts but also the relationship between them.
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