Expiration-forced convergence for basis, calendar, and option-income trades

Expiration as a shared finish line

Futures and cash prices are described as meeting at expiration. That property of convergence is applied to financial futures and to hard commodities. Each contract therefore carries the requirement that its own basis reach zero at its own expiration.

One-month LIBOR futures were specified on a $3 million one-month Eurodollar deposit, and Eurodollar futures on a $1 million three-month deposit. Both contracts cash-settle on the last trading day by subtracting the polled cash offered rate from 100, which is the construction of the IMM index, and they do so without exchanging full face value. One-month LIBOR listed only the first six consecutive months starting with the current month.

A cash-over-futures snapshot

On 7 October 1991, one-month cash LIBOR of 5.25% converted to an IMM index of 94.75, while December futures settled at 94.20. That left a 55-basis-point cash-over-futures basis.

Basis trading against cash

Basis trading, in the sense used here, means taking futures against cash when the futures-spot gap is judged large enough, while the remaining rate move can still dominate the position. The stated futures rule is to buy when futures stand sufficiently below cash and to sell when they stand sufficiently above cash. The trade is classified as speculative with unbounded risk.

Nearby versus deferred bases

Calendar-spread trading here means comparing nearby and deferred futures bases against the shared rule that each contract's basis must reach zero at its own expiration. Accompanying figures note periods when convergence effects matter little, and a case where the December basis was more than twice the September basis, while both bases still had to reach zero at expiration.

Option substitutes and income overlays

A long-option substitute buys calls when the basis favors long futures and buys puts when the basis favors short futures. Deep in-the-money strikes are preferred so that time value, the portion of an option premium that decays with the passage of time, is small relative to the basis gap.

An option-income strategy sells puts when the basis favors long futures and sells calls when the basis favors short futures. Collected time value and the expected basis adjustment are meant to work in the same direction.

Strike choice for sold options is framed as a trade-off between premium size and the breakeven futures price. Moving too far in-the-money reduces time value, and selling a richer option reduces the chance of finishing with a gain.

Scenario comparison, not a single ranking

No alternative is presented as universally best. Each can produce the largest gain under some interest-rate path, so selection is a comparison of scenario results against risk tolerance.

Editorial reading: once the three procedures share the same expiration constraint and the same interest-rate paths, the useful output is a signal to enter, exit, or stand aside, not a claim that one tactic dominates the others.