Quick Answer
Basis is the cash price minus the futures price. A strengthening basis rises (more positive or less negative); a weakening basis falls. The short hedger is long the basis (long the physical, short futures) and benefits when basis strengthens. The long hedger is short the basis (long futures) and benefits when basis weakens.
This section renames the two hedgers from the hedging-theory unit in Chapter 1 by the basis they effectively hold. The labels are counterintuitive on purpose, and reading them correctly is the whole game.
Basis, Strengthening, and Weakening
Basis is the cash (spot) price minus the futures price for the same or a related commodity. This is the convention used throughout this course, and everything below follows from it.
- Basis can be positive (cash above futures) or negative (cash below futures).
- A strengthening basis means the basis rises: it becomes more positive, or less negative. The cash price gains relative to the futures price.
- A weakening basis means the basis falls: it becomes more negative, or less positive. The cash price loses relative to the futures price.
- "Strengthen" and "weaken" describe the direction of change, not the sign. A basis is not "weak" just because it is negative; it weakens only when it falls.
Think of it this way: picture the basis on a number line. Moving right (up) is strengthening, moving left (down) is weakening, and it does not matter which side of zero you are on. A basis going from 35 cents under futures to 30 cents under has moved right, so it has strengthened, even though it is still below futures.
Exam Tip: Gotchas
- "Strengthen" and "weaken" describe how the basis changes, not whether it is positive or negative. A basis moving from -35 cents to -30 cents has strengthened (risen, less negative); a basis moving from -35 cents to -40 cents has weakened (fallen, more negative). Judge by the direction of the change, not by the sign.
Long the Basis: The Short Hedger
A hedger is "long the basis" when they hold a long cash position (they own or will produce the physical commodity) hedged with a short futures position. This is the short hedger from Chapter 1.
- Being long the basis means the hedger has, in effect, bought the basis: they profit when the spread between cash and futures widens in cash's favor, that is, when the basis strengthens.
- A strengthening basis benefits the long-basis (short) hedger: the cash price they ultimately receive improves relative to the futures price they sold, raising their net selling price.
- A weakening basis hurts the long-basis hedger: cash falls relative to futures, lowering the net selling price.
Think of it this way: you own the cash commodity, so you own the thing the basis measures. Owning it makes you long the basis, and just like anything you own, you want its value to go up, which for the basis means strengthening.
Exam Tip: Gotchas
- "Long the basis" means you are SHORT futures (and long the physical). The short hedger is the long-basis party. The basis label is the opposite of the futures leg, so read the phrase as a statement about the basis, not about the futures position.
- A short hedger benefits from a STRENGTHENING basis (cash gains on futures, so the net selling price rises). A question pairing the short hedger with a weakening basis has the benefit direction backwards.
Short the Basis: The Long Hedger
A hedger is "short the basis" when they hold a short (anticipated) cash position (they must buy the physical commodity later) hedged with a long futures position. This is the long hedger from Chapter 1.
- Being short the basis means the hedger has, in effect, sold the basis: they benefit when the spread between cash and futures narrows in their favor, that is, when the basis weakens.
- A weakening basis benefits the short-basis (long) hedger: the cash price they ultimately pay falls relative to the futures price they bought, lowering their net purchase price.
- A strengthening basis hurts the short-basis hedger: cash rises relative to futures, raising the net purchase price.
Think of it this way: you do not own the cash commodity yet; you still have to buy it. Being on the wrong side of ownership makes you short the basis, and like anything you have sold short, you want its value to go down, which for the basis means weakening.
Exam Tip: Gotchas
- "Short the basis" means you are LONG futures. The long hedger is the short-basis party. Again, the basis label is the opposite of the futures leg.
- A long hedger benefits from a WEAKENING basis (cash falls on futures, so the net purchase price drops). Pairing the long hedger with a strengthening basis reverses the benefit direction.
Hedge Type to Basis Position
The two framings map cleanly onto each other, and the direction never flips: the short hedger is long the basis and wants the basis to strengthen; the long hedger is short the basis and wants the basis to weaken.
| Hedger | Cash position | Futures leg | Basis position | Benefits when basis |
|---|---|---|---|---|
| Short hedger (owns or produces the commodity) | Long the physical | Short futures | Long the basis | Strengthens (rises) |
| Long hedger (will buy the commodity) | Short or anticipated | Long futures | Short the basis | Weakens (falls) |
Memory Aid: Own the cash, you are long the basis. Owners want their holding to rise, so a stronger basis helps. The long hedger is the mirror: short the basis, wanting it to fall.
Exam Tip: Gotchas
- The basis label is the opposite of the futures leg, every time. Long the basis goes with short futures; short the basis goes with long futures. If you match the basis label to the futures position instead of reversing it, you land on the wrong hedger.