The prices of Bitcoin and the rest of the crypto market took a nosedive in March 2020 when Coronavirus put mortal fear in the minds of investors and other market participants.
With the extreme selling of Bitcoin, the market entered a state of extreme backwardation where derivatives like Futures trade at a large discount compared to the spot price.
In general, Bitcoin Futures contracts on the Chicago Mercantile Exchange trade at a premium compared to the spot price.
This erased the basis trade for the most part, where a trader would buy Bitcoin in the spot market today and sell Futures for a far-in-the-future date.
By doing this, a trader can lock in the difference between the price of the asset in the spot market and the price of the Futures contract.
What is Basis Trade In Crypto?
Basis trading can simply be described as the difference between the spot price of the digital asset and its Futures contract’s price. This is also known as a cash-and-carry trade in Crypto.
The basis value is, therefore, a value that keeps changing. When the demand is strong, while the supply is limited, spot prices rise in relation to the Futures contract price, hence strengthening the basis.
The value would be negative when the spot price trades lower than the Futures price.
The basis would weaken when the market’s demand is weak, and the supply is large, causing the spot prices to fall in comparison to the Futures contract’s price.
This is typical of the crypto Futures market and is called being in contango, where the price of a Futures contract is higher than the spot price.
Taking a basis trade would mean buying spot Bitcoin (a long position) and taking a short position in the Crypto derivatives market, or vice versa.
Even though the basis value may fluctuate owing to supply and demand forces but the arbitrage traders will help it converge at zero around the expiry date.
The basis value represents the cost of carrying a Futures contract until the delivery date. The price of the Futures contract is dependent on the current spot price plus the cost of carrying in the time before the delivery date.
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Basis Trading In The Crypto Market
Although Bitcoin has taken more than 13 years to reach where it is today, it has now caught the mainstream eye. There is more and more interest in the crypto market, and Bitcoin is its prodigal child.
This increase in interest and regular trading by institutional investors and hedge funds will lead to market inefficiencies being removed in the near future. The current contango state of Bitcoin will be severely less pronounced by 2023 in all the crypto futures trading platforms.
But Bitcoin is not the only cryptocurrency available, and the other coins offer interesting opportunities for Basis trading.
Basis trading in cryptocurrencies is basically buying the asset in the spot (hoping for its value to rise) and taking a short position on the asset via derivative products like Futures contracts or Options.
When traders on both sides of the trade decide to trade a Futures contract, they can agree on a spread or basis rather than an actual price. This spread will be added to the corresponding reference rate for the day to come to a final Futures price.
The point to note here is that the basis is decided before the index level for the day is known.
Looking at the constant innovation in the cryptocurrency space, a fair number of individuals and institutions are coming up with new ways to interact and profit from this novel market. DeFi and NFTs are just some examples of this.
As a trading and money-making strategy, we can expect to see basis trading being widely adopted in the industry.
What Determines The Basis In a Crypto Trade?
The basis value depends on a few factors, and it is important to understand their impact on price before applying the trading strategy.
These factors are the implied financing rate of the Futures contract, the time left for the Futures’ expiry, and the perceived volatility due to upcoming events.
- Basis Trading on CME
On the Chicago Mercantile Exchange, the ticker for a Bitcoin basis trade is BTIC (Basis Trade at Index Close). This allows traders transparency and price discovery on the spread throughout the trading day and also historically.
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The BTIC order book is open for 23 hours every day, allowing enough time for price discovery while traders around the world submit orders against Bitcoin’s current reference rate. These contracts are executed as block trades 24/7 and can be submitted for clearing when the clearing window opens next.
As a trader, you can avail of the reference rate for your Futures contract calculated at either 4 pm London time, or at 4 pm New York time. Both these reference rates come with their own BTIC ticker.
- Basis Trading On Binance
Binance does not inherently support a basis trade, and so it must be constructed.
As mentioned above, you can profit from a basis trade if you buy an asset on the spot while also taking a short position in the derivatives market. In this way, you can pocket the difference in these prices when you square off your positions.
To create a basis trade on Binance,
- Buy 5 $BTC at $17,000 each on the Binance Spot market (long position)
- Take a short position on Bitcoin with 1 contract in the current month’s Binance Futures contracts
- Close the Futures position as the price converges with the spot market
Same way, you may create a Basis trade on Bybit, Kraken or KuCoin-like exchanges.
Risks of Basis trading
As with all other trading strategies, including leverage, you need to be careful of using it according to how good you are at reading the market.
High leverage used by a professional trader can lead to eye-catching profit screenshots.
On the other hand, if a beginner trader decides to gamble 25% of their portfolio on a 125x leverage trade, it can go against them very quickly.
- Market & Price Movement
It may seem like a set-it-and-forget-it type of trade, but in the real world, it is difficult to make sure that every one of these trades will go your way. The financial markets and crypto markets, in general, are notorious for springing surprises on retail investors.
A basis trade is no different and needs to be monitored to decide when to close both the long and short positions.
In the case that the arbitrage opportunity is very evident, traders will jump at the opportunity hence working to decrease the gap between the spot and Futures price.
When you watch the $BTIC ticker carefully, it can give you an indication of the potential turning points in the market.
When Bitcoin is in extreme contango, it is indicative of bullish exuberance and could be a precursor that the market is nearing a short-term or long-term top.
Conversely, when the curve is in backwardation, there could be a bearish sentiment in the market and could be a time for dollar-cost-average entries into your favourite coins.
For these reasons, it makes sense to learn this trading strategy as well as keep an eye on the basis price curve when trading cryptocurrency Futures for a quick update on the rest of the market.