FX futures basis, also known as currency basis, is the difference between the spot price and the futures price of a currency. It is an important concept to understand in the world of forex trading since it can have a significant impact on your portfolio’s returns.
The concept of the FX futures basis arises from the fact that traders can use futures contracts to speculate on the future movements of a currency’s exchange rate. For example, if a trader believes that the euro is going to appreciate against the US dollar over the next six months, they may buy a euro futures contract.
However, since the futures contract has a fixed expiration date, it may not perfectly reflect the currency’s spot price at the time of expiry. This is because the spot price will have moved since the contract was first purchased. The difference between the spot price and the futures price at expiry is the FX futures basis.
The FX futures basis can be positive or negative, depending on the relationship between the spot and futures prices. If the spot price is higher than the futures price, the basis is said to be negative. Conversely, if the spot price is lower than the futures price, the basis is positive.
Why does FX futures basis matter?
The FX futures basis can impact your portfolio in a few ways:
1. Hedging costs – If you use futures contracts to hedge your forex positions, the basis can impact the cost of your hedges. A negative basis will make hedges more expensive, while a positive basis will make them cheaper.
2. Trading returns – If you’re speculating on currency movements using futures contracts, the basis can impact your trading returns. A negative basis will decrease your returns if you bought a futures contract, while a positive basis will increase your returns.
3. Arbitrage opportunities – Experienced traders may take advantage of differences in the FX futures basis by engaging in arbitrage trades. An arbitrage trade involves buying an asset at a lower price in one market and simultaneously selling it at a higher price in another market, thereby earning a profit from the price difference.
How to incorporate FX futures basis into your trading strategies
When trading forex futures, it’s important to keep an eye on the basis and incorporate it into your trading strategies. Here are a few ways to do this:
1. Compare the basis across different contracts – Since futures contracts have different expiration dates, it’s essential to compare the basis across different contracts to get a more accurate picture of where the market is currently pricing the currency.
2. Use the basis to inform your hedging decisions – If the basis is negative, for example, it may be a good time to reduce your hedging activity or look for alternative hedging strategies.
3. Look for arbitrage opportunities – If you’re an experienced trader, keep an eye out for discrepancies in the basis and look for arbitrage trades that offer a profit opportunity.
In conclusion, FX futures basis is an essential concept to understand in forex trading since it can impact your portfolio’s performance and your trades’ profitability. Keep an eye on the basis and incorporate it into your trading strategies for a more informed approach to forex trading.