May 11, 2023
If you're unfamiliar with trading futures in the commodities or cryptocurrency markets, the term "basis" might be new. Basis trading is a popular strategy to exploit price discrepancies and hedge against market risks while adding a market-neutral strategy into your portfolio construction arsenal. In this article, we'll explore the concepts related to basis trading, how a basis trade is carried out, and how it can be used to make market-neutral trades to capitalize on supply and demand dynamics.
A dated futures contract is an agreement where the buyer is responsible for purchasing the underlying asset for a specific price on a predetermined expiration date. The seller must usually physically deliver the goods in commodity markets like wheat, gold, or oil. On the other hand, cryptocurrency futures contracts are mostly cash-settled, meaning that the settlement process involves cash payments. There are, however, physically settled contracts available with certain exchanges as well.
A futures curve is a graphical representation of the price of future contracts versus the time to maturity of those contracts. Typically, the futures contracts that expire further out in the future are priced higher than futures contracts nearing expiration (near-term or current-month futures). This phenomenon is often due to time premiums and cost-of-carry in commodity markets. Although cryptocurrencies do not typically depreciate or have storage issues, they can still trade at premiums to the spot prices of their underlying assets. This can reflect market sentiment surrounding these digital currencies during trading.
When the futures price is above the spot price, the futures term structure is said to be in contango. Conversely, when the futures price is below the spot price, the futures term structure is in backwardation. A market in contango has an upward-sloping forward curve, while a market in backwardation has a downward-sloping forward curve.
As the contract nears maturity, selling pressure results in the futures price moving down and closer to the spot price (spot buying pressure can narrow this gap as well). This creates a scenario where cryptocurrency futures prices converge to spot as time gets closer to expiration. This occurs because the expiring futures contract converges to the spot price, whereas the prices of other futures contracts are still trading at a premium. These costs are more popularly known as contango bleed and can be heavy for cryptocurrencies like Bitcoin, which are usually in heavy contango.
The opposite of contango is backwardation, which occurs far less frequently. In this futures term structure, the futures price is below the spot price. In a backwardated market, a futures contract for the front-month expiries trades at a premium to the back-month. A market in backwardation has a downward-sloping forward curve. This occurs when the futures price trades at a discount compared to the spot price of the underlying asset, like how a contango futures curve could indicate a potential increase in the asset's value over time, a backwardated or inverted futures curve indicates a potential decrease in the asset's value. Markets typically become backwardated when short-term negative price sentiment due to an unsettling amount of fear or uncertainty becomes prevalent. This is like the volatility term-structure meaning of backwardation, where front-month options contracts trade at a premium due to short-term uncertainty.
Perpetual futures, or "perps," are like dated futures contracts but do not have an expiration date. Since they were introduced in 2016 by BitMEX, perps have continued to rise in popularity. The perpetual swaps market for cryptocurrency derivatives has a daily volume of over $100 billion. They are so popular because they eliminate the need for speculators to constantly manage and renew their short or long position in the market. There are also some additional advantages of these contracts, like being easy to short, obtaining leverage, and not having to take custody of the actual asset.
Perps do not have an expiration or settlement date, so how are their prices kept in line with the underlying spot prices? The mechanism used by perpetual swaps to keep their prices tethered to the spot prices is called the funding rate. In crypto, funding rates are like interest taking the form of a series of payments at fixed intervals (usually every eight hours). Traders that hold long or short positions pay or receive these payments to ensure that the price divergence from the spot price caused when they opened their positions are kept in check.
Like contango and backwardation for dated futures, the funding rate is related to whether the perpetual future contract is trading at a premium or discount relative to the spot price of the crypto asset. If the perp is above the spot price, the funding rate is positive, and if it is below, the funding rate is negative. If funding rates are positive and trending upward, this could indicate bullish market sentiment. Conversely, if the funding rates are negative and trending downward, this may indicate bearish market sentiment. This makes sense fundamentally, as negative funding rates getting more negative means more short positions are being opened in the market.
Different exchanges have different techniques for calculating funding rates. They can vary from a complex algorithm considering order book data and market volatility to a simple algorithm using a price averaging mechanism. Because of the way they are calculated, funding rates fluctuate every minute. Generally, funding rates reduce the returns for popular positions. For example, if you have a long position in BTC when the market outlook is highly positive and most people are also bullish, then you would be paying funding rates to people with short positions to keep the perp price in line with its spot price.
As a quick and easy summary of the market dynamics regarding funding rates, when the funding rate is positive, those entering long perp positions must pay those entering short positions. When the funding rate is negative, those entering short perp positions must pay those entering long positions. This makes sense from a fundamental perspective, if the perpetual future is higher than the underlying spot market, which leads to a positive funding rate, longs should be disincentivized to be long, while shorts should be more incentivized to go short to drive the price closer to the spot markets.
The basis is the difference between the spot price of the underlying asset and its futures price. For example, the spot price of gold is $1,800, whereas the price for a futures contract expiring in July is $1,820. In this case, the basis would have a value of $20. It can also be expressed as a percentage by dividing it by the spot price. Basis trading is a strategy traders use to exploit price discrepancies between an underlying asset's spot and futures prices. However, it is not entirely risk-free, as traders must manage counterparty risk and deal with execution challenges during basis trading.
Basis Trading: Truly Market-Neutral?
However, it's important to note that basis trading is not entirely risk-free. While a market-neutral trading strategy involves taking long and short positions to generate profits regardless of market direction, risks are still involved. For example, traders must manage counterparty risk during basis trading. In addition, basis trading with perps can be challenging to execute without slippage because the funding rates fluctuate frequently. Another downfall of basis trading, but something that Paradigm aims to solve, is the execution risk of putting on equivalent-size trades on both the buy and sell side. Finally, efficient basis trading assumes one can enter the trade simultaneously without any price discrepancies, which is difficult without a one-click solution that legs into the trade at once.
In the cryptocurrency world, the difference between the underlying asset and their futures contracts for both dated futures and perps presents the opportunity to implement a low-risk trading strategy called basis trading. A classic example can be seen in the largest cryptocurrency by market cap: Bitcoin. Despite a price surge after the recent banking crisis, its liquidity is nowhere near 2021 levels. This could lead to price discrepancies that can be taken advantage of through basis trading. Don’t want to worry about trade execution or high fees while doing so? Check out Paradigm’s implementation of a single-click execution method to incorporate basis trading into your portfolios. Finally, if you are looking for additional reading material, these previous posts (Basis Basics – Pt 1, Basis Basics – Pt 2, and The Accidental Basis Trader) are highly recommended and provide valuable insights into the world of basis trading.