Taking risks is a huge part of trading, and a lot of my other posts are about that: how to gauge entries, stops and TP levels based on different indicators in order to achieve a good risk/reward ratio. But all this is something called discretionary trading: finding a technical setup on your own and then betting that the market will move in a particular way.
This type of trading is also directional, since the success of your trade depends on the direction in which the market moves. In traditional terms, this is called having a positive delta (if you’re mostly long) or a negative delta (if you’re mostly short).
Delta is basically the relationship between a portfolio and the market: if it’s positive, then you make money if the market goes up, and if it’s negative, you make money if the market goes down. But, as you might see here, there’s another possibility: what if the delta is zero? This is called a delta neutral (or market-neutral) strategy, and it basically means that you’ll have the same outcome regardless of where prices go. And if you play it right, that (pretty much) guaranteed outcome can be making money — no matter where the price goes!
How do you do that? Well, this is where quantitative trading strategies come into play. Unlike with the kind of discretionary trading we’re all used to, there are no indicators to watch, but rather, the opportunities come from different types of market inefficiencies and discrepancies. For example, arbitrage between different (centralized or decentralized) exchanges is a delta neutral quantitative strategy, since you don’t care about where the price of the token you’re arbitraging will be in the future.
Arbitrage isn’t easy, though, and it requires having huge amounts of capital readily available on multiple exchanges. The same goes for funding arbitrage: longing (or buying spot) on one exchange with low funding (and a low futures premium) while shorting on another exchange where the funding and premium are higher. These are more capital-intensive trades, and I might cover them later, but now, let’s look at the market-neutral strategy that’s by far the simplest and requires the least capital: basis trading.
Basis trading is basically profiting from the difference in price between futures and spot. But, unlike funding arbitrage, the kind of futures we’re interested here aren’t perpetuals, but rather quarterly futures that have a fixed expiration date. When the market is bullish, these futures can trade significantly higher than the underlying asset, since a lot of people want leverage, and the resulting price difference between the futures and spot is called the premium. On the expiry date, the futures contracts converge to the price of the underlying asset, so that the premium drops leading up to expiry and disappears on the moment of settlement. More interestingly, the premium can disappear or become negative much sooner than the expiry, namely in case of a flash crash or other bearish events.
The thing is, you can profit from this — and you can profit even more if a flash crash happens. To show you how, I’ll take the example of Bitcoin, but the same thing works for any other asset under two conditions: (1) it has to be available both as a quarterly futures contract and on spot on the same exchange, and (2) you have to be able to use the asset as collateral for trading futures on that exchange. BTC, ETH and other large caps meet both conditions on all the top derivatives exchanges, so it’s just a matter of picking the one with the highest premium.
Back to the example: let’s say it’s September 15th and BTC is trading at $50,000, while the Q4 futures contract with an expiry on December 31st is trading at $54,000. Here, I’ll calculate the numbers for one BTC, assuming a capital investment of $50k, but the same can be done with 0.1 BTC or even less — the percentage return on investment will be the same.
What you would do is buy 1 BTC and, using that as collateral, short 1 BTC on the Q4 futures contract. Given that the premium is $4,000 in our case, you will end up with a guaranteed profit of $4k on the day of expiry (or even much sooner than that, but we’ll get to that). We can calculate the APY by using the following formula:
APY = (Futures price / spot price) ^ (365.25 / days until expiry) — 1
So, in our case, we have:
APY = (54000/50000)^(365.25/107)-1 = 0.3005 ≈ 30%
A 30% APY is pretty wild for something that’s basically risk free. When the market is hyper bullish, you can easily get an APY even higher than that, especially on some altcoins. But you might be confused here: if you’re buying BTC, how is that market neutral? Can you really make the same profit regardless of where the price of BTC goes?
The thing is, you can. On the day of expiry, you close out your futures short and also sell the BTC collateral so that, no matter what happens, your profit will be the same. Let’s take two examples: BTC going to $100,000 at expiry or BTC going to $25,000 at expiry.
In the first case, the PnL on your futures short at expiry will be -$46,000, but the 1 BTC you had as collateral would have gone up by $50,000. The net result of those two numbers? $4k.
In the second case, with BTC at $25,000, your short would be $29k in profit at expiry, and your collateral would lose $25k in value. Your total PnL? Again, a profit of $4k.
Even though you need to buy BTC to open a basis trade, you’re still completely market neutral because you also short the same amount on futures. And, since your collateral is in BTC, you won’t get liquidated in case BTC moons and your short goes deep underwater, because the value of your collateral is increased by the same percentage.
And as I mentioned before, you can make the same profit even sooner, in case the price of BTC drops rapidly. That’s because, in those circumstances, the futures premium often disappears completely as leveraged positions get liquidated. Effectively, it’s like an early expiry; sometimes, however, the futures will trade below spot in a flash crash, meaning that your profit will be higher. These things aren’t predictable, of course, but let’s take a hypothetical example: let’s say that BTC crashes to $35,000 on September 30th, 15 days after you’ve opened the basis trade, and the futures also trade at $35,000.
At that point, you would close your position, by closing the futures short and selling the collateral. Using the same formula from above, but substituting September 30th for the expiry date, we get an APY of 551%, since you made $4k on an initial investment of $50k in just 15 days. And — if the futures are trading below spot when you close the trade, that can be even higher.
So, now you should have all you know about how basis trading works and why the quant firms (think of Alameda, for example), do this a ton. What’s more, this is also helpful in order for you to understand how the derivatives markets work. Basis trading is the most important mechanism by which futures prices are kept close to the underlying asset price; if it weren’t for this, futures contracts could shoot up much higher than spot. Of course, these basis trade opportunities are only possible in a very bullish environment, and you definitely shouldn’t allocate all your capital to a market-neutral strategy making you 30% APY when everything is doing multiples.
But you should always have some capital making you passive, market-neutral income, and basis trading is a great way to do this. The only risk with basis trading is the exchange risk, but this is also the case if you just hold stablecoins on an exchange. Overall, I hope you find this info useful and, little by little, learn to think like the pros.