Deep Dive · Futures · Lesson 7
Speculation
and Basis
Big Idea
Hedgers want to shed price risk. Speculators are willing to take it on — hoping to profit from price moves — and in doing so they supply the liquidity that makes hedging possible. Alongside them sits basis: the gap between the cash (spot) price and the futures price, which shrinks to zero as expiration approaches.
- Speculators take the other side of hedgers’ trades and add liquidity.
- Basis = spot price − futures price, and it converges to zero at expiration.
Speculation is high-risk — most retail speculators lose. The point here is to understand the role, not to sell the trade.
Speculators: The Other Side of the Hedge
For a hedger to lock in a price, someone must take the opposite side of the trade. Often that someone is a speculator. They do not want the physical asset — no barrels of oil, no bushels of wheat — they simply seek profit and are willing to accept the risk the hedger is trying to avoid.
It is tempting to cast speculators as villains, but their role is useful. By constantly buying and selling they add liquidity, so a hedger can find a counterparty quickly and at a fair price. Their trading also helps prices reflect new information as it arrives.
None of that makes speculation easy or safe. It is high-risk, and most retail speculators lose money — the value is in the role they play, not in a promise of profit.
What Is Basis?
Basis is the difference between the cash (spot) price of an asset and its futures price:
- Basis = spot price − futures price
- Spot oil: $74.00
- Futures: $75.00
- Basis: $74.00 − $75.00 = −$1.00
Basis can be negative or positive, and it changes over time as the two prices move. Here the futures price sits above spot, so the basis is negative.
Convergence at Expiration
As expiration nears, the futures price and the spot price come together, so the basis moves toward zero. The reason is simple: at delivery a future essentially is the spot asset, so the two prices must meet.
| Time to Expiry | Spot Price | Futures Price | Basis |
|---|---|---|---|
| 90 days | $74.00 | $75.00 | −$1.00 |
| 60 days | $74.40 | $75.00 | −$0.60 |
| 30 days | $74.80 | $75.00 | −$0.20 |
| Expiration | $75.00 | $75.00 | $0.00 |
At expiration the two prices meet — that convergence is what ties futures to the real market.
Why Basis Matters to Hedgers
A hedge locks in the futures price, but the hedger actually buys or sells at the spot price when the time comes. If any basis remains at the moment they transact, the two prices do not line up perfectly — so the hedge is not perfect either. That residual gap is called basis risk.
Example: a producer locks $75.00 in futures, but at delivery sells the physical oil at a spot of $74.80 — the leftover $0.20 basis is exactly the imperfection basis risk describes.
Contango and Backwardation
The shape of the basis has two names. When futures trade above spot, the market is in contango. When futures trade below spot, it is in backwardation.
Contango
Futures > spot. The forward price is higher than the price today.
Backwardation
Futures < spot. The forward price is lower than the price today.
Interactive Checks
Check 1 of 3
A hedger needs someone to take the opposite side of their trade, and a speculator steps in.
What do speculators mainly provide to the futures market?
Check 2 of 3
A futures contract is approaching its expiration date.
What happens to the basis (the gap between spot and futures)?
Check 3 of 3
A hedger locks in the futures price but ends up transacting at the spot price.
The leftover risk from the gap between them is called:
Common Beginner Mistakes
- ❌ Thinking speculators are pointless gamblers. They take the other side of hedgers’ trades and add the liquidity that makes hedging possible.
- ❌ Assuming the futures price always equals the spot price. The two differ by the basis, which can be positive or negative and changes over time.
- ❌ Ignoring basis risk when hedging. A hedge locks the futures price, but you transact at spot — leftover basis leaves the hedge imperfect.
- ❌ Treating speculation as easy money. It is high-risk, and most retail speculators lose.
Quick Memory Tool
- Speculators take the other side and provide liquidity
- Basis = spot − futures
- Basis converges to zero at expiration
- Leftover basis = basis risk for hedgers
- Futures > spot = contango; futures < spot = backwardation
Next Lesson
Settlement: Physical vs Cash — a contract ends by delivering the actual asset or by paying the difference in cash. Next we look at both, and how traders close or roll a contract to avoid delivery.