Basis trading — Earning contango premium with Bitcoin futures

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.

Introduction to Bitcoin futures and daily settlement

This is the first in a series of articles in which I explore cryptocurrency futures trading, available on platforms like Bitmex and Deribit.

I’ve recently been learning about cryptocurrency futures trading, and am finally grasping some of the core concepts. In this article, I’m going to explain how futures markets work, and in particular the logic of why contracts are settled daily, by building on a simple farmer and baker example I read about at Investopedia.

Imagine it’s January, and a wheat farmer and a baker both need some predictability about the price of wheat on May 1. The baker needs 5,000 bushels of wheat, which is what the farmer needs to sell. They can come to an agreement today to exchange that wheat in May at today’s price of $4 per bushel, and the formalization of that agreement would be called a futures contract.

The baker would be said to be on the long side of the agreement (he has the obligation to buy the wheat) and the farmer would be said to be on the short side of the agreement (she has the obligation to sell the wheat.) The contract price would be $4, and the settlement date would be May 1.

Now lets imagine that on May 1 the market price—usually referred to as the spot price—of wheat is $5 per bushel. Rather than physically delivering 5,000 bushels of wheat, the farmer and baker simply agree to settle the contract in cash. The baker owes the farmer the $20,000 agreed in January (i.e. $4 per bushel for 5,000 bushels), and the farmer owes the baker $25,000 so that he can purchase 5,000 bushels of wheat in the current market (since it now costs $5 per bushel). As a net result, the farmer gives the baker the difference of $5,000.

By doing a cash settlement, instead of physical delivery, both parties retain the outcome of the original contract.

  • The baker gets 5,000 bushels of wheat for their originally planned $20,000, i.e. his original $20,000 plus the additional $5,000 given to him by the farmer to buy the wheat in the market today
  • The farmer gets $20,000 for 5,000 bushels of wheat, i.e. $25,000 received from selling his wheat in the market at today’s price of $5, minus the $5,000 she gave to the baker.

Now, rather than arranging this contract directly, let’s imagine there’s a business that runs a futures marketplace—called an exchange—where the May 1 wheat contract is bought and sold by farmers and bakers (or others who need wheat) who don’t know each other. And to avoid dealing with the contractual physical delivery of commodities, let’s imagine the exchange implements cash settlement.

How could this work?

For starters, the exchange needs to address the risk that the buyers and sellers don’t default on their agreements, regardless of what happens to the price of the commodity over time. The exchange operator could do this by requiring that buyers and sellers deposit some cash that the exchange holds as collateral. Let’s imagine that in the case of our particular farmer and baker, who want to enter into a contract that today is worth $20,000, the exchange requires each to deposit $10,000. In modern futures exchanges, this collateral is called margin.

We’ve seen in the previous example that the price of wheat in May was $5, which resulted in the farmer transferring $5,000 to the baker to cash settle their contract. In this case, the farmer’s $10,000 of margin in her exchange account would have been sufficient for the exchange to settle this contract.

But what would happen if the May 1 market price of wheat was $7, in which case the farmer owed the baker $15,000? The exchange could ask the farmer to deposit an additional $5,000, but what if she didn’t?

How can the exchange address this kind of risk? Through the mechanism of daily settlement.

Rather than wait until May 1 to settle the contract, what if the exchange did a settlement of the contract every day, until May 1? Let’s see how the farmer’s account would look over a contract of, say, five days (just to make the following table shorter), and settled daily:

  • Day, Market Price, 1-Day Change, Settlement, Account Balance
  • 0, $4.00, $0.00, $0.00, $10,000
  • 1, $3.80, ($0.20), $1,000, $11,000
  • 2, $3.60, ($0.20), $1,000, $12,000
  • 3, $4.20, $0.60, ($3,000), $9,000
  • 4, $4.50, $0.30, ($1,500), $7,500
  • 5, $5,00, $0.50, ($2,500), $5,000

For a futures contract of 5,000 bushels at today’s price of $5, that settles daily, we see the same net effect for the farmer—i.e. a total transfer of $5,000—as if the contract settled at the end.

With daily settlement, if the price goes against the farmer for a while, such that her margin (collateral) drops to a dangerous level, the exchange can request that she add additional margin to her account. This is known as a margin call. If she doesn’t, and her margin reaches zero, the exchange can simply close out her position, an event called liquidation, and let another farmer in the marketplace pickup and carry on with the contract.

Since this market model for the trading of commodities doesn’t actually involve the physical delivery of commodities, financial investors began participating simply for the opportunity to speculate on the future price change of the underlying commodity. And naturally, today we have platforms like Bitmex and Deribit that let crypto currency investors speculate on the future prices of currencies like Bitcoin.

This article has explained the fundamentals of futures markets. Here’s some additional comments and issues I’ll address in future articles:

  • In cryptocurrency futures markets, contracts are cash settled in bitcoin. This is unique in that the contract is settled in a difference currency from that in which it is priced.
  • Some crypto currency futures markets allow you to enter long and short positions up to 100 times the amount of collateral you’ve deposited, thereby allowing you to amplify both your potential gains and losses. This is called leverage. The risk associated with using leverage, however, is that a small movement of price against you can result in a liquidation and loss of collateral.
  • Some futures exchanges now offer “perpetual” futures contracts that settle daily, and have no future expiration date. In order to incentivize these contracts to track the spot price, these exchanges have implemented a mechanism by which a small amount of funds are transferred daily between long and short participants depending on the daily movement of the contract and spot prices.
  • In the case of contango, there’s a particular strategy in which a participant goes short, and buys the physical commodity, that result in earning the current premium that exists between the contract and spot prices. My second article detailing how this work.
  • To provide for their services, exchanges charge a fee to participate in a futures transaction, for example 0.05% on entering and leaving a position.

Spanish vs German Directions

I just love the cultural differences in Europe. This Christmas, we played two chess tournaments—one in Spain, and the other in Germany. Prior to the events, we emailed both tournament directors, asking how to get to the venue from the local airport. The contrast in replies are hilarious.

German reply:

The train service to and from Stuttgart Airport will work reliably even on holidays like Dec 25 or Dec 31.
ARRIVAL: If your flight arrives on time, you take the S-Bahn (line 2) at 14:08 h from Stuttgart Airport. There are numerous ticket machines on the way down to the S-Bahn station inside the airport. The fare is EUR 2.80 (EUR 1.30 for children) from Airport to Böblingen. The display will guide you through the ticket buying process in English and, I think, also in Spanish, but if you are unsure how to handle the ticket machine, there certainly are other travellers who can help you.
You will have to change trains at Stuttgart-Rohr (4 stops from the airport) and then take the S-Bahn (line 1) headed for Herrenberg. Böblingen is just 2 stops from Stuttgart-Rohr. If the trains are on time, which they usually are except during rush hour, you will arrive in Böblingen at 14:29.The changing of trains in Stuttgart-Rohr is quite convenient: same platform, opposite track, so there’s no need to use elevators or walk up and down stairs.
From Böblingen railway station, it’s about a 15 to 20 minutes walk to the hotel, but depending on weather conditions and/or luggage, you may want to take a taxi to Hotel Mercure Böblingen (less than 10 EUR). From Böblingen railway station, it’s about a 15 to 20 minutes walk to the hotel, but depending on weather conditions and/or luggage, you may want to take a taxi to Hotel Mercure Böblingen (less than 10 EUR).
DEPARTURE: The first S-Bahn on December 31 leaves from Böblingen station at 5:30 a.m. You change trains just as above in Stuttgart-Rohr and take the S-Bahn line 2, which leaves from Stuttgart-Rohr about 5 minutes later (again same platform, opposite track).
You will arrive at the Airport at 5:52, i. e. about one hour before departure of your flight. This should be enough time, particularly if you have the option to use online check-in – most airlines offer this feature 24 hours before flight departure time.
In case you prefer to take a taxi from the hotel straight to Stuttgart Airport on Dec 31 early morning, I suppose it costs about 35 – 40 EUR, but I am sure the hotel reception staff can give you more precise information. If you have any further questions, don’t hesitate to ask. And just in case, here is my mobile phone number: 123456789. We look forward to welcoming you in Böblingen in December!

Spanish reply:

I think you can take a bus. You’ll have to check.