Cash & Carry Arbitrage
Risk Free Futures Trading Strategy Episode 1 of 2
(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)
Futures have grown to be the most popular derivative product traded by retail participants on the many crypto exchanges offering them.
Made popular by the notorious trading platform BitMex and their infamous 100x leverage trading feature, crypto futures are now globally available across dozens of exchanges.
The price of a future contract very often differs from the underlying spot price, which gives a trader the opportunity to seize this arbitrage and capture a risk free profit through the execution of a cash and carry strategy.
This article will go over the specificities of futures and how to perform a cash and carry trade with Bitcoin futures dated contracts.
Futures 101
A future contract is a derivative product that entitles two parties to exchange an asset at a pre-determined price and date in the future. Unlike forwards, which are typically OTC products, futures are widely available on exchanges to all types of investors and speculators.
Futures were initially designed for commodities hedging before becoming more mainstream and tailored to any type of underlying like stocks and more recently digital assets, on which retail traders mainly engage in speculative trades.
For traditional commodities like Gold and Oil, futures most often trade at a premium relative to the underlying. This normal market condition is called contango. It is in part due to the cost of carry, which can include storage and depreciation of materials. In this case a buyer is willing to pay more for the delivery of an asset in the future. When the future is in contango, a trader is presented with an opportunity to arbitrage the premium.
In rare occasions, futures can also trade below their underlying spot price. This is called backwardation. It occurs when there is a higher demand for a commodity at present than there is in the future, which can be caused by supply shortages or surging demand in panic events.
For Bitcoin, there is no cost of carry, and contracts are usually cash settled. However, the market typically speculates that prices will be higher in the future, thus creating a natural contango condition. This gifts us with an arbitrage opportunity.
We will be looking for a simple cash and carry trade strategy, which consists in buying spot and shorting the future, by first identifying an arbitrage opportunity and then setting up the trade.
Bitcoin futures contracts
You may have noticed that Bitcoin dated futures contracts often have a premium against the underlying spot Bitcoin. In this situation the future is in contango and we have a way to benefit from this price discrepancy by performing a cash and carry trade.
The key concept to consider when scanning the different futures contracts is the time value of money and the opportunity cost that it implies. When getting into a cash and carry trade, we have to keep in mind that we will likely be in the trade until the future expires. And because a dollar today is always worth more than a dollar in the future, we are facing the opportunity cost of having our money parked in a trade while the market could present itself with potentially more lucrative opportunities. So although a far dated futures premium might be larger than a short dated futures premium, we have to take into consideration time value of money and if locking a cash and carry trade for a far dated contract is worth it.
Let’s have a look at some Bitcoin futures contracts on Deribit:
Looking at the above futures, we can see that the December contract offers a higher arbitrage opportunity than the say June contract. As discussed earlier, a far out dated contract usually has a higher premium than a short dated. We thus have a contango condition and upward sloping curve of premiums over time. This presents us with an opportunity to perform a cash and carry trade.
From the above table, we have the possibility to seize a guaranteed $812.97 premium (future price — spot price) for the June contract, while the December expiration gives us an opportunity to capture $2,145.07 per Bitcoin.
These premiums always fluctuate in hand with the price action of spot Bitcoin and can thus extend and narrow. Timing the moment the premium is higher for a given expiration date would give the most profit on our arbitrage strategy.
The below chart displays the price difference between the June 2022 contract and the spot price of Bitcoin. We have the premium amount on the upper half, and the percentage premium on the bottom half. Timing well the moment the premium is at its highest is the most profitable for our cash and carry strategy. We can also notice that the premium goes down over time. This is because of time decay. As we get closer to expiration, our Bitcoin future contract will trade at a closer price to the Bitcoin spot until there is no difference.
The cash and carry trade
Now that we have identified premiums through multiple expirations we can enter the cash and carry trade to profit from this arbitrage opportunity.
The cash and carry strategy consists of buying spot and short selling the futures contract, thus locking in an instant guaranteed profit at expiration.
Using the above table as reference, here is how our set up would look like:
- We buy 1 spot Bitcoin at $36,749.03
- Using our spot Bitcoin as collateral, we short sell 1 Bitcoin June future at $37,562.00
We are now in the cash and carry trade and have locked in a profit of $812.97 at expiration.
At expiration date on June 24, we will:
3. Close the short position entirely by buying back the future.
4. Sell the spot Bitcoin back to USD
We began our trade with $36,749.03 and are left with $37,562.00 at expiration. We have therefore successfully captured the $812.97 premium, all while being completely hedged on both side and taking no directional risk.
Delta neutral exposure
Because we are long spot and short futures, we are totally hedged on both sides and do not care whether the price of Bitcoin goes up or down. All that matters is that the futures premium will trend towards zero as it approaches expiration.
In our case if say at the time we close our positions on June 24 and the price of Bitcoin is $20,000, then we will have lost $16,749.03 on our spot position, but in the meantime our short will have run a profit of 0.8781 Bitcoin [($37,562 / $20,000 -1) x 1 Bitcoin], resulting in a total remaining balance of 1.8781 that we will sell at the the market price of $20,000, giving us $37,562.
On the other hand, if the price of Bitcoin rose to $50,000 at expiration, our future short position will have made a loss of 0.24876 Bitcoin [($37,562 / $50,000 -1) x 1 Bitcoin], resulting in a total balance of 0.75124 at expiration worth $37,562.
Thus, we see that in both cases, we are left with a balance worth $37,562 on the future short position while the price paid for our spot Bitcoin was $36,749.03. Regardless of the profitability of our short future position, we are left with the $812.97 premium.
Our delta neutral position can be visualized as follows:
The USD value is the premium we are capturing, which will go to $0 at expiration. So no matter where Bitcoin’s value goes during the life of our trade, we are making no directional bet and are not exposed to its volatility.
Rollover
Rolling over a position consist in carrying our arbitrage until the next expiration. We could consider doing so if the premium is attractive on the following contract, or if market conditions do not offer us bets that would make us consider the opportunity cost of being in another cash and carry trade. To do so we would simply close our future short and open a new one for the equivalent value of 1 Bitcoin.
