Basis Trading

A form of arbitrage in which one buys an investment vehicle while selling or selling short a similar investment vehicle. For example, one may buy a stock while selling a futures contract on the same stock. Alternatively, one may buy a put while selling a put on the same underlying asset for a different strike price. Basis trading is advantageous when the trader believes there is price inefficiency between the two investment vehicles such that the gain on one will offset the loss on the other. For instance, in the futures contract example, basis trading can be advantageous if the price of the stock plus the cost of carry is less than the price of the futures contract that the investor sells. It is also called relationship trading.

basis trading

An arbitrage operation in which an investor takes a long position in one type of security and a short position in a similar security in an attempt to profit from a change in the basis between the two securities. For example, an investor might purchase a call with an April expiration and simultaneously sell short a call with a different expiration or strike price on the same stock. The investor expects that the values of the two positions will change over time such that a profit will ensue. Basis trading is undertaken when the investor feels one security is priced too high or too low relative to the price of another security. Because of this, the profit on one side of the trade should more than cancel out the loss on the opposite side of the trade. Basis trading may involve an index or group of securities as well as individual securities. Also called relationship trading. Compare program trading.

Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David L. Scott. Copyright © 2003 by Houghton Mifflin Company. Published by Houghton Mifflin Company. All rights reserved. All rights reserved.

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References in periodicals archive

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