Narrow Basis (Stocks) - Explained
What is a Narrow Basis in Stocks?
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What is a Narrow Basis?
A narrow basis describes the proximity or convergence between the spot price of a commodity and the price of that same commodity in a futures contract. In a futures contract, the price for a commodity is set at a future date. The present price of a commodity is its spot price. When the spot price is close to the price in the futures contract or when they vary only at a little rate, a narrow basis has occurred. Efficiency and liquidity in market can be gauged using the narrow basis.
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How Does a Narrow Basis Work?
Simply put, a narrow basis is determined by the difference between the spot price and the futures contract price. This term is used for accounting purposes, especially in the investment or security market. In investment market, a narrow basis is often considered as a small spread between a futures contract price and spot price of a commodity. In a liquid or an efficient market, a convergence should occur between the spot price of commodity and the futures contract price. This means that both prices must be the same as at the time the agreement expires. The formula for determining a narrow basis is; Basis = futures contract price - spot delivery price. Under perfect market conditions, the spot price should be equal to the futures contract price in such a way that the seller makes no more gain than what he would have made in the open market and the buyer does not pay less that the amount he would have paid for the security in an open market. However, due to the fact that prices are sometimes controlled by forces beyond market participants, narrow basis is not guaranteed at all times. When there are imperfect and uncertain market conditions, narrow basis is unlikely to occur. In situations like this, participants of futures contracts leverage on arbitrage opportunities.
Example of a Narrowing Basis
If the spot price for cotton in the open market is $3 as at January 2015 and Jack and Bill enter a futures contract to trade cotton at a future date, January 2016 was set as the expiration date. Given certain market conditions and forces, such as demand and supply, cotton is forecasted to increase from $3 in January 2015 to $4.5 in January 2016. All things equal, if a relative spread occur between the spot price of cotton and the price in the futures contract, in which the prices converge, there is narrow basis.