How To Trade Futures In 3-D: Basis Trading

Futures can be a straightforward and capital-efficient way to either speculate or hedge. You think the price of corn is going higher? Buying a /ZC corn futures contract is an easier way to lay a bet than buying a corn farm and growing your own. How about a short-term hedge on a big S&P 500 stock portfolio, just ahead of a Fed announcement? /ES S&P 500 futures fit that bill. Just like stocks, futures can be long-term trades or quick scalps. But unlike stocks, futures can also offer different trading opportunities because of their basis, which few novice individual traders know about.

Basis 101

“Basis” is the term for the difference in futures prices in different expirations, or the cash (“spot”) price of the underlying product and the futures price. Futures prices in the various expirations are different from each other and the spot price because of the cost of carry, and the impact of supply and demand. That difference represents the basis. /ES futures, for example, have contracts that expire in March, June, September, and December. /ZC corn futures have contracts that expire in March, May, July, September, and December. /ZB bonds, /GC gold and, /CL crude oil futures have their own set of expirations.

Trading Basis

In a word, basis trading is buying a future in one expiration month, and selling it in a different expiration month—like selling the March /ES and buying the June /ES. It’s sort of like intermarket pairs trading, but with near 100% correlation. You’re speculating on the basis increasing and widening, or decreasing and narrowing. Because the two futures are based on the same underlying (e.g. S&P 500, Treasury bonds, crude oil, etc.), they are highly correlated. They tend to move up and down at the same time. But when they don’t move at the same time, or by the same amount, the basis changes.

Because the basis can be negative, where the price of the further expiration future is lower than the price of the nearer expiration future (also known as “backwardation”), it’s important to know which way you think the near-term future may move, relative to the back-month future. Some futures like /ES are regularly in backwardation, so the basis widening means it becomes more negative. If you thought it would widen, you might consider buying the near-term future and shorting the back-month future (e.g., you’d buy March /ES and short June /ES).

When the price of further expiration futures are higher than nearer expiration futures, that’s called “contango.” In contango, the basis is positive. If /CL futures are in contango, and you thought the basis would widen, you might consider shorting the near-month /CL future, and buying the back- month /CL future.

Basis Trading In the Real World

You may consider the futures basis because they can be traded by themselves, kind of like stocks pairs trades. For example, maybe you don’t have a bullish or bearish bias on the futures’ underlying product itself. But considering the futures basis, you think it might move higher or lower.

Trading the futures basis also has potential advantages over stock pairs trading. First, the contract and tick size are the same for a given future. You don't need to adjust the quantities of the trade to account for different contract specification. Second, the margin requirement for the basis trades can be lower than for a single long or short future because the basis trade is simultaneously long and short futures. The basis tends to have smaller price changes than the individual future would. So the margin requirement is also smaller.

Let’s look at three futures basis trading scenarios.

Crude Oil (/CL)
Crude oil futures contracts typically go out a couple of years. They’re one of the most liquid, actively traded futures contracts, and the basis can move around a lot. To understand why, think about how crude oil gets turned into gasoline and other “stuff.” It gets pumped out of the ground and transported to a refinery, and that costs money. If the oil is stored, there are insurance and storage fees, as well as interest charges if you’re borrowing money to buy it.

All those things go into the basis of /CL futures, and would make the further-term futures more expensive than near-term futures because those costs are built into the futures’ prices. But with the futures basis, there’s also the expectation of over- or under-supply in the coming months and years. You can see that when you look at /CL futures prices. Backwardation in /CL can happen when the market sees a shortage in crude oil, and where near-term demand outstrips immediate supply. The price of the near expiration /CL future is pushed higher than the back month. But /CL is more often in “contango,” where the carry costs make the back months slightly higher than the near months, and there is Backwardation in /CL can happen when the market sees a shortage in crude oil, and where near-term demand outstrips immediate supply. The price of the near expiration /CL future is pushed higher than the back month. But /CL is more often in “contango,” where the carry costs make the back months slightly higher than the near months, and there is equilibrium between supply and demand. If you see /CL in backwardation and you think the causes are temporary, and that /CL will move back to contango, you could consider shorting the near-expiration /CL and buy the further-expiration /CL. The risk, of course, is that /CL could move further in backwardation, resulting in a loss on the trade. And there’s never a guarantee that contango has to happen in the future. But the trade could be profitable if the futures move back to contango before the expiration of the near-term future.

S&P 500 Index (/ES)
One of the most widely watched and actively traded futures is the /ES contract based on the S&P 500 stock index. /ES trades until 3:15 p.m. CT during “regular” market hours. The price of /ES is based on the value of the stocks in the S&P 500 (which is the SPX index), and the cost to carry the portfolio of those stocks. There is an interest charge to borrow money to buy shares. The interest is offset by dividends that are paid by the S&P 500 stocks.

The net impact of interest and dividends determines the basis between the / ES and the SPX. Nowadays with interest rates low relative to dividends, /ES futures are usually in backwardation, and the basis doesn’t fluctuate much. But because S&P 500 stocks stop trading at 3:00 p.m. CT, so, too, does the price of the SPX stop updating. And in the 15 minutes between 3:00 p.m. and 3:15 p.m., when the /ES continues to trade, it can move higher or lower than what the basis calculation would suggest based on news that arrives after 3:00 p.m., or on the opening of large positions in /ES in the last 15 minutes of trading that anticipate the next day’s price movement.

If the /ES to SPX basis is $-10, when the /ES moves up relative to where SPX closed and makes the basis $-8, for example, that can signal a stronger open the next day. If / ES moves down relative to the SPX closing price to make the basis $-12, that can signal a weaker open the next day. Looking at the /ES to SPX basis before and after 3:00 pm can give you a clue as to the next day’s opening price action. This may impact stop orders, and even technical indicators you might be tracking.

CBOE Volatility Index (/VX)
Volatility futures might be the trickiest to understand. But they might offer the most interesting opportunities. The CBOE Volatility Index (VIX) is derived from the out-of-the-money SPX option prices. When traders anticipate larger price changes in the SPX (i.e. more volatility), the out-of-the-money SPX option prices can increase in price. That, in turn, pushes up the VIX. When traders anticipate smaller price changes in the SPX (i.e., lower volatility), the out-of-the-money SPX prices can drop, which in turn drives the VIX lower.

You can’t trade the VIX directly, and /VX futures are a way to speculate on the direction of volatility. But /VX futures are only modestly tied to the VIX. “Modestly” because /VX settles to the VIX settlement value at their expiration. But there isn’t any cost of carry between the VIX and /VX futures be- cause you can’t buy the VIX like you can buy crude oil or a stock portfolio. That makes /VX futures pure indications of how much future volatility the market anticipates. The basis you see between the near and further month in /VX futures reflects whether the market sees more volatility near term or longer term.

Most of the time /VX futures are in contango—where the market expects more volatility the further into the future you look. But when the market panics and drops, generally the VIX rallies the most, the closest expiration /VX future rallies a bit less, and further expiration /VX futures rally a little less than those. That can push /VX futures into backwardation, and make the basis negative.

Figure 2 charts just this scenario, when a market dropped and pushed volatility higher, and the /VX basis became negative.

Most of the time, the price of the back-month /VX future is higher than the price of the near-month /VX future, and the basis is positive. When the market became more volatile, the basis became negative. If you believe the market will calm down, and the front-month /VX will drop relative to the back month, and the basis will go from negative to positive, you could consider shorting the front-month /VX future and buy the backmonth /VX future. That trade could be profitable if the basis goes from negative to positive. But the trade would lose money if the basis became more negative—which is something that happened in the 2008 market crisis.

At the closing bell, /VX basis trading isn’t for the faint of heart. If you’re already a proficient futures trader, consider this another tool in the strategy toolbox. But even if you’re not ready to trade it, /VX basis can certainly offer you clues as to how the market is forecasting volatility.