In this Article:
1. Arbitrage in the volatile crypto market2.
What is spot future arbitrage?
3. What is perpetual future contracts?
4. What is Funding rate?
5. Risk associated with crypto arbitrage strategy
The highly volatile cryptocurrency market gives most investors the idea of a high-risk, high-reward investment. It's common to see a coin go up to 20% and then correct by 20% the next day. In addition to the spot market, many exchanges also offer perpetual futures contracts, which allow traders to leverage up to 125x, further increasing the volatility of the cryptocurrency market.
The inefficiencies between each market, on the other hand, provide us with a plethora of arbitrage opportunities. Arbitrage tactics make it simple to attain 15 percent to 50 percent APR.
An investor can speculate on the direction of an asset, commodity, or financial instrument via a futures contract. Let us now turn our attention to the arbitrage itself. These futures typically trade around, but not exactly at, the spot price. They are sometimes more expensive (futures trade in contango), and sometimes they are less expensive (futures trade in backwardation). The difference between spot and futures prices is known as basis, and as the time approaches expiration, it tends to reduce until it reaches zero. This means that if futures prices fluctuate significantly from spot prices, there may be an opportunity to buy one and sell the other (depending on which is cheaper/more costly).
Bullish Bitcoin investors can lock in a substantial position in the future market by locking in a price that is just a little higher than the present price at a later date. To put it another way, if the current price of Bitcoin is $50,000 and you believe it will be $80,000 in three months (but you don't have the cash to buy a large position right now), it's a simple decision to enter into a futures contract to buy a large quantity of Bitcoin in three months at a price of $60,000. ( Premium to spot)
Bitcoin quarterly futures generally trade at a slight premium to spot of 2 or 3 percent, but due to the rapid growth of BTC, the premium has risen to more than 25% for contracts expiring at the end of May. The premium is still nearly 23% at the time of writing this post.
To take advantage of the premium, purchase BTC on the spot market, transfer cash to a futures account, and sell the matching number of futures. Futures and spot prices must be the same at expiration, ensuring that the deal will make a profit. You must lock in the rates as soon as possible before the arbitrage disappears.
Perpetual futures contracts, unlike standard futures, do not have an expiration date, allowing traders to trade them similarly to spot trading. One of the reasons perpetual futures contracts are so popular in the crypto world is because of this. Traditional futures contracts usually settle once a month or once a quarter. The contract price converges with the spot price at settlement, and all open positions expire. Exchanges require a system to ensure that futures and index prices converge on a regular basis because perpetual futures contracts never settle in the traditional sense. This procedure is also known as funding rate.
The funding rate guarantees that futures and index prices converge on a consistent basis. Long positions must pay shorts when a perpetual futures contract trades at a premium (higher than spot markets) due to a positive funding rate. Short positions, on the other hand, pay longs when the futures price is below the index price.
The majority of crypto market investors prefer to retain long positions rather than short positions, which implies long-term traders must pay funding rates to short-term traders.
- Because you must perform three procedures to lock in the profit (1. buy crypto on spot market, 2. transfer to futures account, 3. sell futures), there is a chance that the price will change before you complete all three processes.
- The possibility of receiving a margin call if the spot price rises significantly (and the basis rises). This risk, in my opinion, should only be controlled if you trade long-term contracts. This risk is quite unlikely in short-term contracts.
- There's a chance the exchange will be hacked or go bankrupt.
New financial instruments are continually being developed by cryptocurrency exchanges, allowing investors to adopt more sophisticated strategies and better control risks. Crypto futures have opened up new prospects for all traders and investors. Spot-futures arbitrage can be a profitable strategy, but it's important to be aware of the hazards.