The ultimate guide on how to trade expirables
Also, the information below refers to Contango’s v1 product: expirables. This version has been sunset in late 2023.
The information provided below is for research purposes only. It should not be used as investment advice. Trading on leverage carries significant risk. If you are a beginner DO NOT trade on leverage.
Contango is a brand new DeFi primitive that opens up a completely new derivative market: expirables.
What can expirables be used for?
At a high level, expirables are just like any futures contract in CeFi or TradFi. But they also unlock new use cases that are specific to the DeFi space. For a detailed recap of expirable unique features read this.
The goal of this article is to provide a comprehensive overview of possible use cases. We have grouped them in 3 areas:
1. Speculation
2. Hedging
3. Arbitrage
We accompany each scenario with detailed examples which you can find on this spreadsheet (it’s read-only so make a copy for yourself in case you want to play with numbers).
1. Speculation
Just like in TradFi, expirables can be used to speculate.
If you are bullish on ETH, you go long (you will get delivered ETH at expiry), and if at expiry ETH price is higher than the price you paid when you entered the position, then you have a profit.
If you’re bearish on ETH, you go short (you will deliver ETH at expiry), and if at expiry ETH price is lower than the price you paid when you entered the position, then you have a profit.
You can apply the same reasoning for stable vs stable pairs, like DAIUSDC: if DAI trades below $1 and you expect it to regain the 1:1 peg with USDC, you can long DAI with up to 10x leverage.
Remember: you can amplify your gain (and losses) with leverage. Trading on leverage carries some risk as you can easily get liquidated and lose your initial investment.
Example:
Let’s say the current spot price of ETH is 1000 USDC.
The sentiment is optimistic so the market is currently in contango: the expirable price of ETHUSDC is 1010 (the basis is thus +1%).
A trader believes the price of ETHUSDC will go up over the next few months. So she buys (goes long) 1 ETHUSDC, at a price of 1010 USDC.
She posts 400 USDC as collateral (so leverage is around 2.5x).
At expiry, the trader choses physical delivery and thus receives 1 ETH for the original price paid of 1010 USDC regardless of the ongoing spot price (note: she needs to bring the remaining 610 USDC to close her position).
If, as expected, ETH appreciates even more to 1100 USDC and the 1 ETH is sold for USDC then she makes a profit of 90 USDC.
Her Return On Equity (ROE) is 90 USDC / 400 USDC = 23%
If instead she cash-settles at expiry, she doesn’t need to bring the remaining 610 USDC (but will be exposed to price impact). Her ROE is also 90 USDC / 400 USDC = 23%
Set up your own example here.
2. Hedging
Expirables can be used to hedge investments by taking the other side of the market, e.g. go long on an asset and go short on the expirable instrument on that same asset.
You can hedge with perps but you have to face the unpredictability of funding fees (charged e.g. every 8h).
The only premium you pay with expirables is the cost of the expirable itself (aka basis rate), which is always known upfront.
Example:
A trader buys 1 ETH with the idea of hedging the same amount on Contango to be delta-neutral and earn some extra rewards on ETH at the ongoing rate of, say, 5%.
If the current spot price is 1000 USDC, she needs to short the same notional of 1 ETH by posting 0.4 ETH as collateral on Contango (so leverage is around 2.5x). She uses the remaining 0.6 ETH to farm ETH rewards at 5% during 6 months, thus earning 0.015 ETH.
Let’s suppose the expirable price of ETHUSDC is 1010, and at expiry the spot price (which will be equal to the expirable price) is 1200 USDC.
At expiry the spot leg gains 200 USDC, while the short loses 190 USDC, thus leaving the trader with a net profit of 10 USDC (0.0083 ETH), which is indeed the basis spread (this is indeed a cash and carry example, see below).
If she’s accounting her profits in ETH, her ROE is (0.015 ETH + 0.0083 ETH) / 1 ETH = 2.33%. She effectively hedged her position, earning some extra profits in the meanwhile.
Set up your own example here.
3. Arbitrage
3.1 Arb with CeFi futures
Contango prices expirables via interest rates, while in CeFi dated futures are priced through order books. This means that there could be price differences and hence arb opportunities.
Maturities won’t always match exactly, so you might be exposed to price risk on one leg after expiry. Also, trading with leverage carries some risks and you can get liquidated, so you need to monitor your positions often and rebalance if needed.
The rationale behind this trade is to long the cheapest instrument and sell the most expensive one.
Example:
A trader sees that ETH futures price on Binance is higher than ETH expirable price on Contango, and the maturities for both contracts are similar.
She opens a short leg on Binance for 1 ETHUSDC at a futures price of 1100 USDC, posting 400 USDC as collateral.
She then opens an opposite long on Contango for 1 ETHUSDC at an expirable price of 1000 USDC, posting 400 USDC as collateral.
At maturity she will realize the spread between the two prices, 100 USDC. Indeed at maturity, by definition, futures/expirable prices will be equal to the spot price. If the latter is 1150 USDC she will gain 150 USDC on the long and lose 50 USDC on the short.
Her ROE is 100 USDC / (400 + 400) USDC = 12.5%.
Set up your own example here.
3.2 Cash and carry
The cash and carry trade is well-known in TradFi. The rationale behind this trade is: when markets are in contango (the futures price is higher than the spot), you create a delta-neutral position by buying an asset spot (cheaper) and short the same asset with a futures (more expensive), thus realizing the spread between the two prices at maturity.
A perp version of this trade has become the most popular alternative in DeFi: if the market is in contango and the funding fees are positive, the idea is to create a delta-neutral position with a 50% spot leg and 50% short perp leg that receives periodical funding fee payments.
Both scenarios are well described on Artur Hayes’s blog.
For the first time in DeFi, thanks to Contango, you can try out both cases:
- Buy an asset on Contango and short it with a perp, to receive funding fees (for this trade to be profitable, however, the spread between spot and expirable should be lower than the expected money you’re going to collect from funding fees).
- Buy an asset spot and short it on Contango, making the basis spread (example below).
Example:
A trader buys 1 ETH spot at a price of 1000 USDC.
She then shorts 1 ETHUSDC on Contango at an expirable price of 1100 USDC, by posting 0.4 ETH as collateral (so leverage is around 2.5x). The order size should be 1100 USDC.
At expiry, she opts for physical delivery: she closes her short by bringing the missing 0.6 ETH and receives 1100 USDC in exchange, thus making a 100 USDC profit regardless of the spot price. If, say, the spot price at expiry is 1200 she is gaining 200 USDC on her spot leg and losing 100 on her short.
Her ROE is: 100 USDC / 1000 USDC = 10%.
Additionally, while her position is opened, she could earn some extra profit on her remaining 0.6 ETH.
Set up your own example here.
3.3 Arb interest rates between stables
Since Contango prices expirables via interest rates, it also offers an easy way to arb existing rates differentials between stablecoins, with up to 33x leverage. The profit of this trade comes from the basis rate, which is given by the differential in interest rates.
This is indeed kind of similar to a cash and carry trade but without the hedge on the spot: the assumption is that the spot price when you enter the position will be the same at expiry.
Example:
DAI interest rate is 6% and USDC rate is 3%. Assuming DAI expirable price is 1.0300 USDC, a trader can short 1000 DAI with 120 USDC (around 8x leverage, which is reasonably safe given that stables don’t deviate too much from $1) and wait for expiry.
Indeed at maturity, DAI expirable price will align with the spot again, at 1.000 USDC. If the trader decides to cash-settle her position, she will receive 1030 USDC, thus netting 30 USDC as profit.
Her ROE is 30 USDC / 120 USDC = 25%.
Set up your own example here.
About Contango
Contango is bringing expirables to DeFi. Buy or sell assets at a set price and date in the future without order books or liquidity pools. When a trader opens a position, the protocol borrows on the fixed-rate market, swaps on the spot market, then lends back on the fixed-rate market. Contango offers physical delivery and a minimal price impact for larger trades. Join us at contango.xyz.
