Basis Trading - A New Way to Make Money off Cryptocurrencies

Basis Trading - A New Way to Make Money off Cryptocurrencies

As worries about Covid-19 rocked global markets in early 2020, Bitcoin plummeted by nearly 50%. The market slipped into dramatic backwardation as Bitcoin fell in value (with futures trading at a significant discount to spot). In 2021, the price of Bitcoin and Ethereum (ETH) have been equally erratic, with severe drops and high surges, which appear to be impacting the pricing of other cryptos.

During a severe selloff in June, Bitcoin futures, which generally trade at a premium to the spot price, retreated, largely eliminating the basis trade in which a trader would buy Bitcoin in the spot market today and sell long-dated futures, locking in the difference between the two values.

The Bitcoin and cryptocurrency markets have been at a critical crossroads since the first half of 2021. Crypto still pales in comparison to major capital markets, despite having a market valuation and liquidity that may have appeared unimaginable just a few years ago. Big institutions have limited liquidity and lack market access, which forces them to take on enormous credit risks just to dip their toes in the market.

Many companies are still intrigued, however, and some are already taking part. Not only because of the asset class's attraction but also because of trading opportunities that aren't available anywhere else. Some risk/reward ratios are simply too appealing to pass up, and one such option is referred to as Basis Trading.

What is Basis Trading?

The basis trade entails purchasing a commodity at its current price (having a long position) while concurrently taking a short position using derivatives such as options or futures contracts. The two will eventually converge, at which point a profit will be obtained.

Practically every trader, hedge fund, and associated high-frequency trading algorithm hunts for and capitalises on basis trade opportunities in mature, liquid markets. Because of the crowding, the spread between spot and futures prices narrows, lowering the profit potential of this technique. The risk associated with this Bitcoin trading technique is virtually 0 with an almost guaranteed profit, which may sound too good to be true at first glance.

Every day, $7 trillion is traded in foreign exchange. Bitcoin's total market capitalization is $1 trillion, and the crypto market's relative lack of liquidity and market access leads to a market scenario known as "contango," in which the futures price trades at a premium to the spot price.

Bitcoin normally trades in contango, but in commodities markets, one must typically store and transport the product, thus the futures price is greater than the spot price, due to all the expenses that must be added to the current price. Backwardation, in which futures trade below spot, is the polar opposite of this.

Basis trading in the current crypto market

While it took 12 years to reach the current level of adoption, current market inefficiencies could be eliminated in the near future. Bitcoin's current contango will be substantially less pronounced by 2023.

While that may seem like a long time in the crypto realm, it demonstrates how quickly the market has matured. Consider how few in the traditional investment sector took bitcoin seriously just a year ago. Its market capitalization was once less than $200 billion, but it has since soared to more than $1 trillion. Furthermore, there is a slew of other cryptocurrencies that differ significantly from BTC and offer intriguing opportunities for Basis Trading!

Buying spot crypto (taking a long position) while concurrently building a short position through derivatives such as options or futures contracts, or vice versa, is essentially all that is involved in basis trading with cryptocurrencies. This may fluctuate due to supply and demand changes, but due to arbitrage dynamics, it will converge to zero at expiration. Going long or short on a futures contract implies you can lock in a futures contract's forward purchasing or selling price on the assumption that you will retain the contract until its delivery date.

A futures price is calculated using the current spot price plus the cost of carrying for the time between delivery and delivery. The basis is the cost of carrying that contract.

Participants can trade futures at a predetermined spread to the closing underlying index level or reference rate through BTIC. This index level for CME Group crypto goods is the transparent and controlled CME CF Reference Rates for Bitcoin and Ether.

When a buyer and seller agree to trade futures contracts, instead of agreeing on a particular price, they agree on a spread or basis, that will be added to the corresponding reference rate for that day to establish the futures price. This basis is decided on before the index level for the day is known.

Going by the fact that many individuals and institutions are coming up with newer and more innovative ways to interact with the crypto market, coupled with the advent of NFTs and advanced DeFi systems, we can expect to even see widespread adoption of basis trading in this industry! Either way, this is definitely something that every crypto trader should keep an eye on.

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