You run a company that makes brain pills, supplements you advertise as "powerful mind builders and IQ enhancers." The pills mostly consist of sugar and soy. As such, you buy a lot of both commodities. But, looking at weather reports, it seems like there might be a shortage in the futures, with prices likely to go up. You'd like to lock in a price now for the sugar and soy you'll need for your upcoming production; that way, your expenses don't spike if prices for the commodities go up.
Time to short the basis. It's a futures strategy that allows to you to guarantee a reasonable price in the future. You're going to need the sugar and soy for your manufacturing process, so you want to lock in a price you can handle.
So, instead of waiting until you need the items and paying spot prices (the prices you would pay if you went out into the market when you needed the commodities), you purchase a futures contract now, set to deliver at the point you will need the sugar and the soy. You now know the price you are going to pay for those commodities.
When a party shorts the basis, they purchase a futures contract as a hedge against some future commitment to deliver the underlying commodity. In this case, the future commitment was the manufacturing process for the brain pills. It could also come up in a situation where you were a middleman for the commodity.
Like...say you have a side business providing sugar to a manufacturer of diet pills. You buy the sugar on the open market and sell to your diet pill clients. You need to deliver the sugar to them every month, i.e. you have a commitment to deliver that commodity. You can use the short the basis technique to hedge against price jumps...locking in prices today with a futures contract, so you have a guaranteed price for the sugar you're selling down the line.
Related or Semi-related Video
Finance: What is a Short Sale and what i...5 Views
finance a la shmoop what is a short sale and what is shorting stock
alright you sell a footballer's short when you mumble something about them [Guy looking angry in a sports bar]
never making it to the NFL right think about that all you recruiters who picked [The guy gets punched]
Chad Pennington and Marc Bulger ahead of Tom Brady in the draft Tom made it he's
done you know pretty well for himself and eventually you had to quote buy him [Tom Brady on the field with his hands on his hips]
long unquote when it was clear that he would end up being an NFL icon you'd [Brady celebrating with confetti falling]
have to recognize his real value to the game alright well the same gist is true
with stocks you sell Facebook short because you think the stock is [Stock trader surronded by screens]
overpriced you don't like zucks politics and the
government will regulate the company because of it or because well you just
think that kids who quote made Facebook unquote have migrated to competitors or [Goat going to use a computer]
well they just like the outdoor all right well the process of shorting well [Goat walking around in a field]
you call your broker explain what you want to do she quotes you the borrow or [Defintion of a borrow]
price at which she will loan you shares of Facebook so that you can then sell
them short like say it's a 1% a month it's kind of a borrow number the borrow
was way more expensive than normal margin rates like that's 12 percent a [Borrow calculation shown]
year if you're doing the fancy math there and then you just go ahead and
virtually sell say yeah a thousand shares of Facebook at four hundred bucks
a share sold them short four hundred thousand dollars short position on
Facebook if the stock then goes up 30 bucks well guess what your 30 grand in [Stock chart for facebook showing price increasing]
the hole and that shows up structurally as margin encroachment yeah we like [Big red arrow pointing to the margin encroachment]
football terms and the ticker is FB after all right so if your entire
account only had a hundred grand in it remaining of a margin availability well [ATM showing 100 grand of margin availability]
you're kind of getting into that red zone soon with only 20 grand of room
between you and that 50% margin maximum as it normally applies to retail [Bar showing 'you' approaching the margin maximum]
investors on the other hand if it turns out that well the zuck was actually an [Newspaper front page about Zuckerberg being an Al-Qaeda member]
al-qaeda rep trying to mess with America via making its politics extreme and it's
discovered that he was under Russian spy direction and he's indicted and half the
population angrily turns immediately away from Facebook and the stock [Other newspaper stories]
suddenly drop a hundred bucks well then you've [Stock chart showing price plummeting]
notionally made a hundred grand that's a thousand shares times a hundred bucks
shorted it right you shorted it four hundred down to three hundred you're a
thousand shares times hundred bucks and money why just notionally well because a [Gain calculation is shown]
you still have the short position yes you're in the money with it but you
still hold it short be because you're still paying that one percent a month
interest on the borrow to hold that short position all right so how do you
remove the notionally tag and just get your winnings of a hundred grand you buy [Notionally tag attached to a sack of money is cut up]
the shares that's called unwinding the short and [Unwinding the short stamp]
yet you just go into the market instruct your broker to buy a thousand shares
that the $300 a share it's trading at now deliver those shares to the [The shares are handed over to the brokerage]
brokerage that loaned them to you and then close out your position to book a
tidy hundred grand in profits on your short and you celebrate until you stop [Guy throws a load of money in the air]
why stop because you remember that all gains from the shorting of
stock are taxed at the userís ordinary income tax rates meaning you don't keep
anywhere near that hundred grand of gain if you live in a blue state you'll [Blue states shown on a map of the US]
probably keep something closer to half that amount and you know the old saying [The stack of cash is halved]
buy low sell high while this one is a just sell High buy low that's the long
and the short of it
Up Next
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