Why is perfect hedge not possible?
A perfect hedge is the one which eliminates any risk. For example, if a natural long position gains $100 on every $10 move up and loses $100 on every $10 move down, a perfect hedge would do precisely the opposite. It would lose $100 on every $10 move up, and gain $100 on every $10 move down. You can see that for a long spot position, a hedge position in a futures market would be a short with the same notional value.
In reality, however, a futures price does not correlate identically to the spot price. The only time we can be sure that the futures price is the same as the spot/index price is at the time of a final settlement (contract expiry). This is because there’s no more uncertainty left as to where the final contract settlement price will be. Hence, the basis at the expiry always equal to zero.
If a hedger is closing a futures position before the contract expiry (which is often the case), it is impossible to know the size of the basis at that time. In other words, while the spot position produces some gain or loss, futures gains or loss will not correlate perfectly in most cases. This is what represents the basis risk.
Let’s consider a scenario, where an individual will receive one bitcoin in two months but wants to lock in the USD value today. The current spot price is $4,000 and the futures with expiry in three months is trading at $3,500 (such a difference between the prices is highly unlikely, and only used to provide a clear example).
Amount to hedge: 1.00 BTC
Underlying spot price: $4,000 BTC/USD
Underlying futures price: $3,500 BTC/USD
Basis: $500 ($4,000 - $3,500)
Hedge duration: 2 month
Contract expiry: 3 months
At the moment of opening a hedge position, futures are traded at a discount (also known as backwardation). You can already see that due to the basis, entering a short futures hedge at the same price as the spot price is not possible. If the futures were above the spot (known as contango), this would be a more favourable position for a short hedge. Opening a short position at a higher price would allow to lock in a future selling price which is even more than the current spot price.
After two months, hedger receives one bitcoin, sells it at the current spot market and closes a short hedge position simultaneously. The effective selling price of one bitcoin is the current spot price plus the gain/loss on a short futures position.
Amount to hedge: 1.0 BTC
Underlying spot price: $3,100
Underlying futures price: $3,000
Basis: $100 ($3,100 - $3,000)
Short futures p/l: $500 (Entry - Exit = $3,500 - $3,000)
Effective selling price: $3,600 (Spot + Futures p/l = $3,100 + $500)
You can see that at the time of the hedge opening, at $4,000 spot, hedger was not able to get that same selling price with the futures hedge after two months. The reason is the price difference between futures and spot, or the basis risk.
If the individual did not hedge though, the selling price for one bitcoin would’ve been just the spot price of $3,100. The gain on the short position helped to offset some losses.
Basis change can worsen or improve the hedge
Note that the increase in basis would’ve helped even more. If the closing futures price were even lower, the profit on a short position would increase, giving the higher selling price for one bitcoin. If the opposite would happen, and the basis would decrease or even go negative (contango), the short futures hedge would have less profit, and the effective selling price the hedger was trying to lock in would’ve been less.
Short contango and long backwardation
The good rule of thumb is that if you have a short hedge position, you want the market to be in contango at the moment of opening (futures above spot, negative basis). Throughout the hedge duration, you benefit even more if the basis increases and goes positive (futures go closer to spot from above and preferably below it).
In contrast, if you have a long hedge position, it is preferred to open it when the market is in backwardation, and the basis is positive (futures below the spot). During the life of the hedge, your position will improve if the basis decreases or goes negative (futures approach the spot from below and go above it).
The basis risk is inherent to all futures contracts and arises from the fact that futures do not correlate flawlessly with the spot price of the underlying asset. The basis itself is the difference between the spot price and the futures price. If a hedge position needs to be closed before the contract expiry, it is impossible to know what the basis will be at the time of exit. Because of this, the futures hedge position will never perfectly offset the gains and losses of the underlying asset.