Basis: Definition and Examples in Finance
Although the term “basis” holds various meanings in finance, it most frequently refers to the difference between the prices and the expenses involved in transactions when calculating taxes. Such usage relates to the broader terms “cost basis” or “tax basis” and is specifically used when capital gains or losses are calculated for income tax filings.
In another context, basis refers to the variation between a deliverable commodity’s spot price and the futures contract’s relative price. A basis may also be used for securities transactions. Simply put, a security’s basis is its purchase price after commissions or other expenses.
Basis in the Futures Market
In the futures market, basis represents the difference between the commodity’s cash and futures prices. It is a critically important concept for portfolio managers and traders to grasp because the relationship between cash and futures prices affects the value of the contracts used in hedging. But the concept is also fuzzy at times because there are gaps between spot and relative price until the expiry of the nearest contract; therefore, the basis is not necessarily accurate.
In addition to the deviations created because of the time gap between the expiry of the futures contract and the spot commodity, there may be other variations due to actuals, different levels of product quality, and delivery locations. Investors generally use the basis to assess the profitability of cash delivery and look for arbitrage opportunities.
Basis as Cost
A security’s basis is the purchase price after commissions or other expenses. It is also known as cost basis or tax basis. This figure calculates capital gains or losses when a security is sold. For example, let’s assume you purchase 1,000 shares of a stock for $7 per share. Your cost basis equals the total purchase price, or $7,000.
Failure to file Form 8606 may result in double taxation of these amounts and an IRS-assessed penalty of $50.1. For example, let’s assume your IRA is worth $100,000, of which $20,000 is nondeductible, which accounts for 20% of the total. This basis ratio applies to withdrawals, so if you withdraw $40,000, 20% is considered basis and is not taxed, which calculates to $8,000.
Conclusion
- In finance, basis generally refers to an investment’s expenses or total costs.
- It can also refer to the difference between the spot price of an asset and its corresponding derivative futures contract.
- Basis has essential tax implications because it represents the costs associated with a product.
