Basis

Basis has two common meanings in finance. It may refer to the cost attached to an investment for calculating gains or losses, or to the difference between cash and futures prices.

• Cost basis generally starts with the amount paid for an investment and may need adjustments after certain transactions.
• Capital gain or loss is calculated by comparing the amount received from selling an investment with its applicable cost basis.
• In futures markets, basis measures the difference between the cash or spot price and the related futures price.
• Basis can be positive or negative depending on the relationship between the two prices.
• Basis trading involves long and short positions and can carry significant risk when leverage is used.
   

Cost basis generally refers to the original cost of an investment for tax purposes. Depending on the type of transaction, this amount may later need to be adjusted.
For example, suppose you purchase an investment for a certain amount. That purchase cost is generally your starting basis. If a transaction such as a stock split changes the number of shares you hold, the basis per share may also need to be adjusted.
Cost basis is important because it is used to work out the gain or loss when an investment is sold. In simple terms, the amount received from the sale is compared with the applicable cost basis.
Keeping accurate cost records is therefore important for tax calculations. The exact tax treatment of capital gains, including whether an investment is treated as short-term or long-term, depends on the applicable tax rules rather than a universal one-year rule.
Reinvested distributions also need to be recorded correctly when they are used to purchase additional investments. This helps ensure that the appropriate cost of those additional holdings is considered when gains or losses are calculated.
 

In futures markets, basis refers to the difference between the cash or spot price of an asset and the price of its related futures contract.

For example, imagine the cash price of a commodity and its futures price are different. The gap between these two prices is called the basis. Depending on the market convention being used, the calculation may be expressed as cash price minus futures price.

Basis is important for traders and portfolio managers because cash and futures prices do not always move by exactly the same amount. The relationship between them can therefore affect a hedge.

Differences can arise because of factors such as time until the futures contract expires, product quality, delivery location, storage and other market conditions.

Traders may also study basis when assessing cash delivery or looking for possible price differences between related markets.

Additional read: Commodity market timings

Basis trading involves taking positions in related cash and futures markets based on the difference between their prices. It usually involves a combination of long and short positions.

Here is what these positions mean:

• Long position: You buy and hold an asset because you expect its value to rise.
• Short position: You sell an asset with the expectation that its price may fall, with the intention of buying it back later at a lower price.

For example, a basis trade may involve taking opposite positions in an asset and its related futures contract. The outcome depends on how the difference between the two prices changes.

Leverage may also be used in such trades. However, leverage increases exposure and can magnify losses as well as gains.

Additional read: Quick assets

Leverage can be a major risk in basis trading. Leverage means using borrowed funds or a smaller amount of capital to take a larger trading position.
For example, if leverage allows you to control a position much larger than the money you put in, even a relatively small unfavourable price movement can lead to a larger loss.
Short positions can also carry substantial risk when prices rise instead of falling. When leverage is involved, these losses can become larger because the trader has greater market exposure.
Therefore, the possible risks and costs of leverage need to be considered carefully before entering a basis trade.
 

Basis is an important concept in finance, but its meaning depends on the context. For investments, cost basis refers to the cost used to calculate capital gains or losses when an asset is sold. In futures markets, basis refers to the difference between the cash or spot price and the related futures price. Understanding these meanings can help investors interpret tax calculations, futures pricing, hedging strategies, and basis trades more clearly while considering the risks involved.