Basis and Cash-Futures Convergence

The cash market is allowed to disagree until it cannot.

Advanced 6 min read Course 48 of 60

Course 48 of 60 in the futures hub. Basis is the gap between cash and the listed future, it has its own dollars, and it doesn't have to close on the day a hedge needs it to.

Cash and Futures Are Allowed to Disagree Until They Cannot

Cash minus the future is the usual way to write basis, and the sign flips depending on who is quoting, so say which way you mean before you trade the gap. The cash leg is what a commercial actually holds: inventory, a location, a grade. The future is the listed contract you can click, and it has an expiry clock on it. Financing, storage and dividends live in the gap. It is a market with its own buyers.

Listed euro futures against a dealer spot quote are a basis of another kind. That pair of prices is covered in the forex course. On a futures statement the gap that matters is cash against the listed contract, whether that cash is an index or a commodity.

1. What basis is

Equity index futures are the plain case, because the cash leg is the index and the future is ES, MES, NQ or MNQ. They will print different numbers while time is left. Dividends and financing over the days remaining are an ordinary reason. Crude is the physical version. CL is 1,000 barrels and it is delivered, so location and storage get a vote that a stock index doesn't have. One story for both gaps is how the dollars come out wrong.

Day to day, small moves in the gap are often those carry items. I would not promote a quiet wiggle into a hidden signal. A blow-out is a different event. Price the residual once you know the tick. A theory about when the gap ought to vanish doesn't size the trade.

Basis ≈ cash − future (sign conventions vary). It is allowed to move Cash market the thing commercials hold inventory / location − Listed future the thing you can click expiry clock spread basis

2. Who lives in it

Commercials and desks that can make or take delivery are the people who live in the gap. They hold the inventory, or they are set up to take delivery of it. Most accounts looking at a screen hold none of that. If you can't name the location and the grade, you are a guest in someone else's market. Guests get hurt by assuming the gap closes on their schedule.

A 20-tick residual on ES is 20 times $12.50 = $250. Against a $268 cap the room left is $268 minus $250 = $18, so the gap is almost the whole cap.

Run the same 20 ticks through the contract you actually hold, and set the dollars next to the cap. The futures contract size calculator has ES, MES and CL on its list. Give it your cap, your entry and a stop 20 ticks away, and it does the division. On MES the same 20 ticks are 20 times $1.25, which is $25, because the micro is a tenth of the e-mini. On CL a tick is $10, so 20 ticks are $200. Ignore the $250 ES residual and you are running a second trade the size of nearly the whole $268.

3. When it blows out

Before expiry, cash and the future are allowed to disagree by more than the carry you penciled in. The gap can widen. A hedge that assumed a quiet basis has just become two trades: one in the cash thing, one in the future. Point them the same way by accident and both can lose together. The drawing's blow-out panel is that moment.

Width is a number you write while the gap is boring. I don't know when a blow-out ends. Nobody publishes a schedule for the snap-back. Past the dollar width you already accepted, you cut, or you admit you are speculating on the gap.

Cash and futures are allowed to disagree until they cannot normal basis blow-out A hedge that assumed a quiet basis just became two trades.

4. Hedge ratios

Start with dollars of cash exposure divided by the dollars in one future, then cut the ratio because basis moves. For ES, one contract is $50 times the index. The count itself comes from your own cash book and the day's index level. Whole contracts leave a leftover even when the division is honest. The haircut is the part the 20-tick line already priced: $250 on ES can remain after a hedge that ignored the gap and called itself flat.

Equity-index futures run on the March, June, September, December cycle and expire against the opening index value on the third Friday. That print is when the index future and the cash index are forced to meet. It isn't a promise the gap behaves this week. CL trades in every calendar month and is physically delivered. Its clock is delivery. People who should run a basis book can name the cash leg. Almost everyone else should leave it.

Hedge ratio is dollars of exposure, then a basis haircut contracts ≈ cash $ ÷ future $ per unit then haircut for basis Who lives in basis commercials / arb desks You usually should not When to leave it if you cannot name location and grade Convergence is a clock, not a promise this week

5. When to leave it alone

Guests should read the question on the drawing before they click. Do you hold the cash object? A commercial with a real book has basis as a job. Without the cash object, trade the future outright or skip the spread. There is no third choice where the gap is free money because a textbook said it closes.

Dates move, and so do delivery rules. The delivery and cash settlement lesson covers how the contract actually ends, cash settlement or delivery. Know that ending before the gap becomes interesting.

Are you a commercial with a cash book? Do you have the cash object? Basis is your job you hold the cash leg Leave it alone trade the future outright or skip

6. Mistakes, limits, takeaways

The first mistake is a convergence date you made up because the hedge felt old. Next is copying a basis trade off a video when you don't hold the cash. Another is calling storage, financing or dividends a secret signal. Another is using the ES tick on a crude residual, or the crude tick on an index residual. The 20-tick line is three different dollar amounts depending on the contract. Mix them and the cap is a story. Grading whether any of this paid you is a different job from putting the trade on. The track-record lesson covers results after costs, the worst streak, and how many trades the number rests on. A few tidy convergences are a short sample.

Basis shrinks toward zero into expiry

Into expiry the gap generally shrinks, because at the end the future and the cash thing have to line up. On ES, MES, NQ and MNQ that meeting is the opening index on the third Friday of the contract month. Before that Friday, financing and dividends can hold the futures price away from the cash index. A small gap on an ordinary Tuesday is just carry.

Continuous charts still jump at the roll for anyone who only trades the future. You stitched a new month on. The cash index didn't have to jump by the same amount. CL's ending is physical delivery of 1,000 barrels. The calendar doesn't speed up because a hedge is dull.

Basis, briefly

  • Basis is cash minus the future, and the sign depends on who is quoting.
  • Twenty ES ticks are 20 times $12.50, which is $250, leaving $18 under a $268 cap.
  • The same 20 ticks are $25 on MES and $200 on CL.
  • ES, MES, NQ and MNQ meet the opening index on the third Friday. CL meets delivery.
  • If you can't name the cash leg, skip the basis. Trade the future outright, or stand aside.

Past the dollar width you wrote down, the hedge is already two trades. Educational only. Not a recommendation to buy, sell, or hold any contract or pair.