This is the second in a series of articles that explore cryptocurrency futures trading, available on platforms like Bitmex and Deribit. The first, and introduction to Bitcoin futures trading is found here, and in this article I’ll discuss “basis trading”.
On this page of the Bitmex documentation, in which they discuss market conditions known as contango and backwardation, the following is stated:
A trader can use this as a trading strategy: a futures contract trading at a large premium can be sold and the underlying asset bought so that the trader is market neutral and will thus earn the basis if they hold till settlement.
In this post, I want to walk through a numerical example to clarify how the above—referred to as basis trading—actually works. But first, we need to define some terms.
What is a bitcoin futures contract?
When you buy a bitcoin futures contract, you own the right to buy bitcoin, on a particular date known as the settlement date, at a particular price. This is known as taking a long position.
Conversely, when you sell a bitcoin futures contract, you own the right to sell bitcoin on the settlement date, at a particular price. This is known as taking a short position.
On platforms like Bitmex and Deribit, when the settlement date arrives and the contract is settled, the price difference is transferred by the platform, and paid in bitcoin. If I own the right to buy 1 BTC at $10,000 on the settlement date, and you are the counter-party, with the right to sell 1 BTC for $10,000 on the settlement date, and the spot price of bitcoin is $11,000, then Bitmex, on that date, will transfer $1,000 worth of bitcoin from your account to mine.
As you can imagine, a futures contract that settles tomorrow will probably trade today pretty close to the spot price, but a contract that settles three months from now will trade today at the price the market believes the spot price will be in three months.
If the 3-month contract price is higher than the current spot price, then the market is said to be in contango, and the price difference, referred to as the “basis” or “premium”, is positive. If the 3-month contract price is less than the current spot price, then the market is said to be in backwardation, and the premium is negative.
Now let’s look at that strategy…
With all that as background, let’s return to the trading strategy mentioned at Bitmex, and walk through a numerical example to see if this actually works.
Given this point, a trader can use this as a trading strategy: a futures contract trading at a large premium can be sold and the underlying asset bought so that the trader is market neutral and will thus earn the basis if they hold till settlement.
Imagine the Dec 28 contract is trading at $7,000, with spot BTC trading at $6,500. We’re in contango, and the premium is $500. So in this strategy, I sell 1 BTC of futures contracts, giving me the right to sell 1 BTC on Dec 28 for $7,000. And then I go buy 1 physical BTC at the spot price of $6,500. I’ve paid a total of $13,500.
Dec 28 arrives, and BTC spot is trading at $10,000. I lose $3,000 on my BTC short contract, but I make $3,500 on my physical BTC, netting me $500, which is exactly the premium in play three months earlier.2
What about the case in which the spot price of BTC is lower on Dec 28, for example if BTC spot is trading at $5,000? In that case, I make $2,000 on my contract, and I lose $1,500 on my BTC, again netting myself exactly the premium of $500.
And we see that, yes, this strategy does work (and in the process, we beginners now understand futures a little better.)
What about using leverage?
When you deposit 1 BTC at Bitmex or Deribit, you’re not limited to buying or selling futures contracts limited to 1 BTC. Depending on the platform, you can actually buy or sell contracts of up to 100 BTC or 50 BTC, respectively! This is called leverage.
Leverage allows you to amplify both your potential gains and losses. Say with your 1 BTC of collateral, you buy 2 BTC of futures at $6,500. And let’s say the spot price drops such that at settlement date BTC is trading at $5,000. In that case, you’d lose $3,000 (corresponding to 2 BTC) rather than $1,500, had you not used leverage. Vice-versa if the price of BTC goes up.
In addition to loss amplification, leverage also carries the risk of liquidation. The platform, at all times, has to ensure your 1 BTC is sufficient to cover your losses, meaning that in the above example, at anytime between purchase and the settlement date, the market price of BTC drops to a level at which your 1 BTC collateral couldn’t cover further losses, the platform will immediately settle your contracts, and you’ll lose your collateral.
With that disclaimer, let’s look at a contango example with leverage.
The Dec 28 contract is trading at $7,000 and spot at $6,500. We use our 1 BTC deposited at Bitmex to sell 2 BTC of bitcoin short futures, meaning the right to sell 2 BTC on Dec 28 at $7,000. Then we buy 2 physical BTC at $6,500. Our total cost is $20,000.
Dec 28 arrives, and the BTC spot is $8,000. We lose $2,000 on our futures contracts, and gain $3,000 on our physical BTC, netting a total of $1,000, or twice the $500 premium existing at purchase time.
The liquidation risk is that at some point prior to settlement date, the spot price of BTC goes to $14,000, such that the contract position loss on a 2 BTC position is $14,000 or 1 BTC. In that case, your short position would be liquidated, and you would lose your 1 BTC collateral (worth $14,000). However, you’d have the 2 physical BTC you purchased for $13,000, now worth $28,000. If you immediately sold those, your net would be $28,000 – $13,000 – $14,000 = $1,000.
In this way, it would seem to me that when the market is in contango, it would be sensible to use as much leverage as you can support purchasing of the physical commodity (bitcoin), to maximize the multiple of premium you can earn.