Basis is one of the most important concepts in hedging. You have probably heard terms like "local basis" and "capturing the basis" before, and it seems to refer both to the price you get at your local elevator versus the exchange and the difference between the price today and the price in a futures month. So what exactly does basis mean?
Basis is the difference between the price of a futures contract and the underlying commodity's cash (or "spot") price.
To put it in a simple equation:
Cash Price - Futures Price = Basis
So, with this definition you can see how basis would refer to both of the scenarios above - the local elevator vs. Chicago futures price, and the price today (new crop cash price) vs. the futures price.
Think of the futures price as the price of the grain in the global market, and the local cash price as a localized version of the global market. Local supply and demand, transportation costs to the nearest terminal or Chicago, elevator storage costs, and even interest can factor into that basis number. Generally speaking, the closer you get to the futures month, the basis approaches zero as the local cash price and futures price converge; but this can also change based on local market conditions.
Basis is so important to hedging precisely because this difference allows you to capture value with a hedge. As a producer, you will be selling the grain in the future, and your goal for hedging is to transfer your price risk to the market and protect yourself against declining market prices. So, you want to be "short" the market price (protect against price decline) and "long" the basis (benefit from basis increase). So, as a producer you are looking for an increasing, or strengthening, basis. Remember, basis is about the relationship between the cash price and futures price. You can have decreasing prices and a still have a strengthening basis, because the basis is the difference between the two.
Let's take an example. We have an Illinois corn farmer with 550 acres who predicts his 2016 yield will be 100,000 bushels. Today, September 2016 corn prices are up to $4.08. This is great news, because it is over the cost of production for many producers! So, we can lock in the September 2016 futures price at $4.08 and ensure that we will be profitable for the season. Let's say our local cash price is 25 under the nearby (25 cents under the Chicago July 2016 price of $4.06), at $3.81. That 25 cents is accounting for transportation to Chicago, elevator storage costs, local estimates of supply/demand, and interest (currently minimal).
At harvest, the September 2016 futures price is at $3.64. The farmer sells his grain at his local elevator, where the local cash price is eight under the nearby (Chicago September 2016 price) at $3.56, and the elevator offsets (liquidates) his September futures position.
Cash Futures Basis
May 31, 2016 3.81 - 4.08 = -.27
September 1, 2016 3.56 - 3.64 = -.08 ------------------------------------------------------------
Net -.25 +.44 +.19
Nineteen cents may not seem like much, but when you have 100,000 bushels, nineteen cents per bushel translates to $19,000 extra dollars in your pocket.
Capturing the basis by locking in a futures price is just one way that the mathematics behind Hedge My Farm can help you manage your price risk. By using a mathematically optimal mix of futures and options, and moving positions only when the statistics of the market tell the model to do so, Hedge My Farm is able to show you an optimal position, which you can then take to your broker or other trusted adviser to help you make an informed market decision.
This article from Iowa State University Extension has additional detail on basis in the grain commodities.