One of the most exciting things about FarmLead since my arrival has been the launch of the Basis Negotiation feature.
Today, let’s jump right into it and talk about the basics of basis trading and some of the terminology.
You probably know the importance of basis in making marketing and sales decisions.
But it can always be a little confusing when you walk through the math.
Let’s get started.
Defining and Calculating Basis
Basis is the difference between the local spot (cash) price and the futures market price for the time and delivery of the commodity.
The futures market is important because it offers a buyer an opportunity to hedge and shift the price risk associated with the volatility of the asset.
Typically, we are discussing a futures market price from the Chicago Board of Trade or another futures exchange like the one in Minneapolis (MGEX), where Hard Red Spring Wheat is traded.
Here’s a simple example of how it works.
Let’s say that a farmer wants to sell soybeans in Decatur, Indiana on June 20. The local elevator price may be $9.00.
Meanwhile, the July futures quote at the Chicago Board of Trade is $9.35.
The basis is the difference between the local cash price and the futures price.
In this equation: $9.00 minus $9.35.
The basis would be -$0.35.
Here is where the terminology comes into play.
The basis for the Decatur-based farmer would be called “35 under July.” All we’re stating in this example is that the local cash price for his or her oilseeds would be below the July soybean futures contract.
But there’s another important factor that the basis tells us.
When the basis is below the futures contract, one can properly guess that the local market has enough of the grain or oilseed.
When supply increases, we traditionally witness a decline in the basis.
Is 35 Over July Possible?
In the example above, we just stated that the Decatur farmer’s basis is “35 under July.”
Does that mean there is a scenario where a basis price could be “35 over July”?
This time let’s take a look at a situation where there might be a shortage of grains. If a local market in South Dakota doesn’t have enough wheat, we may see the local cash spot price surpass the value on the futures exchange.
Let’s say that the hypotetical cash price for Hard Red Winter Wheat is $5.50 in the local market of Corsica, South Dakota (About 90 miles West of Sioux Falls.)
However, on the Minneapolis Grain Exchange, the July Futures contract for Hard Red Winter Wheat is trading at $5.25.
The basis is $5.50 minus $5.25… or $0.25.
What Else Impacts Basis?
The basis is important because it can provide individuals with a glimpse into local market conditions, especially when it comes to supply and demand. Grain quality, availability, the impact of weather all play into the supply and demand balance.
But it isn’t just supply and demand that impacts the basis price.
Other factors include transportation costs, borrowing costs, and storage costs. Any farmer knows the cost of shipping and transportation. The further that a seller may be from the local elevator or export terminal, the higher these costs become.
Tomorrow, we’ll dive deeper into the features of the FarmLead Basis Negotiation tool. We’ll teach you how to post an offer and start trading right away.
Enjoy your Wednesday.