Strengthening basis
Also written Strengthening of basis · Basis strengthening
A change in basis (spot minus futures) towards a more positive or less negative number — spot rising relative to futures — which benefits a short hedger.
In plain language
Basis is spot price minus futures price. It moves every day, and the direction it moves in decides who gains.
The basis strengthens when it becomes more positive or less negative. From -50 to -40 is strengthening, even though it is still negative. From +15 to +20 is strengthening too.
In price terms, strengthening comes from spot rising and/or futures falling relative to each other — a move from contango towards backwardation. As expiry approaches in a contango market, the basis strengthens all the way to zero, because spot and futures converge.
How it works
The definition (Chapter 5, section 5.6):
Basis = Spot price - Futures price
Strengthening: basis becomes more positive or less negative
Who benefits. A short hedger — long the physical commodity, short futures — gains when the basis strengthens. His spot position gains relative to his futures position.
| Market | Basis change | Benefits |
|---|---|---|
| Contango | Strengthening | Short hedger |
| Contango | Weakening | Long hedger |
| Backwardation | Strengthening | Short hedger |
| Backwardation | Weakening | Long hedger |
The hedger's result equals the change in basis. For a short hedger, the gain on spot minus the loss on futures is (Spot change) - (Futures change), which is exactly the change in basis.
What moves the basis (Chapter 5): seasonality of crops, depleting inventory, expected demand, weather, freight, handling, storage, insurance, interest rates, logistics and the time left to expiry. In agricultural markets, expected quality rejections at warehouses or weak monsoon forecasts can inflate contango.
A worked example
The workbook's simple case.
| Day | Spot | Futures | Basis |
|---|---|---|---|
| 1 Jan | 1,100 | 1,300 | -200 |
| 15 Jan | 1,200 | 1,350 | -150 |
The basis moved from -200 to -150: strengthened by 50. A short hedger (long spot, short futures) gains +100 on spot and loses 50 on futures — net +50, the change in basis.
The workbook's short-hedger table (contango).
| Date | Spot | Futures | Basis |
|---|---|---|---|
| 1 July | Buy at 1,100 | Sell at 1,800 | -700 |
| 15 July | Sell at 850 | Buy at 1,200 | -350 |
| Result | -250 | +600 | |
| Net | +350 |
Spot fell 250, but futures fell 600. The basis strengthened from -700 to -350, and the hedger made 350 — again the change in basis.
In rupees. If those prices are per quintal and the hedge covers 100 quintals (illustrative):
Spot loss = -250 x 100 = Rs -25,000
Futures gain = +600 x 100 = Rs 60,000
Net = Rs 35,000
Note that prices fell and the short hedger still gained more than he lost. Strengthening is about the gap, not the direction of prices.
Why NISM asks about it
Chapter 5, section 5.6 (Basis), defines strengthening and weakening, gives the -50 to -40 illustration, the 1 January / 15 January table, the market-type table and the contango short-hedger example. It connects to the long hedge and short hedge in section 5.2 and to contango and convergence in Chapter 3. Expect "which hedger benefits from a strengthening basis?" and a table calculation.
Common exam traps
- A negative basis can strengthen. -50 to -40 is strengthening; the sign of the basis does not decide it, the direction of change does.
- Strengthening benefits the short hedger, in both contango and backwardation.
- Basis is spot minus futures in this workbook. Reversing the subtraction reverses every conclusion.
- Strengthening does not require prices to rise. In the workbook example spot fell 250 and the hedger still made 350.
- Convergence strengthens a contango basis to zero by expiry.
- The workbook's dating is loose. It says Mr X tracked the basis "in the month of June" while the table runs 1 July to 15 July. The arithmetic is unaffected.
- Section 5.6 also says strengthening is associated with rising spot and/or falling futures. In the contango table both fell; what matters is that futures fell more.
Check yourself
1.A commodity's basis changes from Rs −50 to Rs −40. What has happened?
- a)The basis has weakened, and the market is moving from backwardation towards contango
- b)The basis has strengthened, and the market is moving from contango towards backwardation
- c)The basis has weakened because it is still a negative number
- d)The basis is unchanged in real terms because both figures are negative
Show the answer
Answer: (b) The basis has strengthened, and the market is moving from contango towards backwardation
"A change of basis FROM Rs −50 TO Rs −40 INDICATES A STRENGTHENING BASIS, EVEN THOUGH THE BASIS IS STILL NEGATIVE."
The two definitions to hold on to:
Option (c) is the trap that catches most students — they see a negative number and assume weakness. But the sign of the basis tells you the market condition (negative = contango), while the direction of change tells you whether it is strengthening. Those are two different questions.
And the direction of travel: "STRENGTHENING OF BASIS IS ASSOCIATED WITH INCREASE IN SPOT PRICES AND/OR REDUCTION IN FUTURES. In such a case the market is said to be MOVING IN A DIRECTION FROM CONTANGO TO BACKWARDATION."
This has to happen eventually, because the basis must narrow to zero as the contract moves towards expiry — "with the expiry of futures and convergence, contango disappears, and basis strengthens from a negative number (like −40) to zero."
Who profits from it: strengthening basis benefits the SHORT hedger.
2.A processor hedges his raw material purchases by going long futures. Which basis movement benefits him?
- a)Strengthening basis, in a contango market only
- b)Weakening basis, in both contango and backwardation markets
- c)Strengthening basis, in both contango and backwardation markets
- d)Weakening basis, in a backwardation market only
Show the answer
Answer: (b) Weakening basis, in both contango and backwardation markets
"LONG HEDGE is associated with LONG IN FUTURES and selling in spot. Thus, LONG HEDGERS BENEFIT IF THE BASIS WEAKENS, i.e. FUTURE PRICE GOING UP AND SPOT PRICE COMING DOWN. Generally, long hedge happens FOR RAW MATERIALS BY PROCESSORS, wherein the processors expect their raw material prices may increase."
And the market-type table confirms it holds in both conditions:
Market Type Basis Preferred position Contango Strengthening Short hedger Contango Weakening ⚠️ LONG hedger Backwardation Strengthening Short hedger Backwardation Weakening ⚠️ LONG hedger Options (a) and (d) are built on the assumption that the market condition matters. It does not. Contango and backwardation describe where the basis IS; strengthening and weakening describe where it is GOING — and only the second determines who gains.
The intuition: a long hedger is long futures and will sell in spot. He therefore wants futures to rise relative to spot — which is precisely weakening basis, since basis = spot − futures.
The mirror case: "SHORT HEDGE happens with FINISHED GOODS by processors/manufacturers. SHORT HEDGERS BENEFIT WITH STRENGTHENING OF BASIS, i.e. spot price going up and futures price falling."
Where this is taught
Free preparation for NISM Series XVIRelated terms
- Basis riskThe risk left over after hedging, because the exposure and the contract used to hedge it do not move identically — in size, in expiry date, or in what they are written on.
- ConvergenceThe certainty that a futures price and the spot price of its underlying meet at expiry — because on the last trading day the contract settles at the cash market price, leaving no room for a difference.
- BasisThe difference between the spot price and the futures price of an asset — positive when spot exceeds futures, negative when futures exceeds spot, and zero at expiry.
- Short hedgeA hedge made by selling futures to protect an existing holding or a planned sale against a price fall — the futures gain offsets the lower cash price, locking in roughly the futures price.
- ContangoA market in which the futures price sits above the spot price, normally because the futures buyer is paying for the cost of carrying the commodity through to delivery.
- Weakening basisA change in basis (spot minus futures) towards a less positive or more negative number — futures rising relative to spot — which benefits a long hedger.