What is basis trading

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Basis trading is an arbitrage trading strategy that seeks to profit from perceived mispricing of securities. If a trader believes that two similar securities are mispriced relative to each other, they will take opposing long and short positions in the two securities in order to profit from the convergence of their values.

This strategy is called basis trading because it typically aims to profit from small basis point changes in value between two securities.

Breaking down basis trading :

Basis trading  for example a trader who sees two similar bonds as mispriced would opt to take a long position  in the bond thought to be undervalued, and a short position in the bond which would then be seen as overvalued.

The trader’s hope is that the undervalued bond will appreciate relative to the overpriced bond, thus netting him a profit from his positions. In order make a worthwhile profit, they would have to undertake a large amount of leverage in order to increase the size of their positions. This use of large degrees of leverage is the greatest risk involved in basis trading.

Basis trading is common across futures commodities markets, “where derivative products are readily traded against each other as well as in conjunction with their underlying assets, as one future trading site Daniel’s trading explain “In addition to commodities, basis trades typically involve contracts based upon debt instruments, currencies or equities indices.