Basis Contracts: Purpose
Math of a Valuable Marketing Tool
Basis contracts allow a farmer to deliver grain he cannot store, maintain a long position in the futures market and get a cash advance at delivery, usually 70% of the cash price the day the basis contract is established.
If futures increase in price, the farmer makes penny for penny.
If futures decrease in price, the farmer loses penny for penny.
The math for basis contract using Poet at Iowa Falls prices is:
The 30% of the cash price left with the merchandiser is used to finance in the merchandiser's futures account a long futures position in the futures month chosen by the farmer.
If the futures price declines 30%, that 30% of the cash price is gone.
Just before it is gone, the merchandiser should call you and tell you need to send him money to finance the futures position or liquidate the basis contract.
Sounds like a futures position, doesn't it?
That is because it is a futures position.
The difference between a basis contract and a futures position in your futures account is, in a down market, you will lose a lot more money with a basis contract than a futures position.
A basis contract requires 30% of the value of the corn to own a futures position.
A futures contract requires 10% of the value of the corn to own a futures position.
When you have a margin call from your broker or merchandiser, you will correctly conclude the market is not doing what you expected.
Thus, in a down market, farmers lose 20% more money with a basis contract than a futures contract.
With corn at $6.50, 20% is $1.30!
But farmers are more "comfortable" with basis contracts than futures.
What are you willing to pay for "comfort"?