Futures Arbitrage, A Trading Strategy for Market Uncertainty

Note: Though we are using Bitcoin for simplicity in this article the same futures arbitrage method can be applied on any asset which has futures contracts available. Such as Altcoins, Gold, Oil, and Currencies among others.

At the time of writing this Bitcoin is at a crossroads for traders. Hovering just above 10000$. It might as well be up to a coin toss whether we continue upwards or head lower. Volatility is nearing lows, and low volatility always precedes high volatility. Essentially, there is a large price move incoming but we do not know which way.

Bitcoin Volatility Index (BVOL)

Now how do we trade such a scenario? Do we take a side and pray that its right? Risking price moving sharply against us. Do we sell all or coins in hopes we buy them back lower. The opportunity cost being that you lose out if price rises sharply. You could do either of these and bet right and make money or you could lose. We need to find a happy medium between these two. One where our risk to the upside or downside is neutral yet we can still profit off volatility. This is where Futures arbitrage steps in.

Before we get into the actual method for futures arbitrage we will first run through some basic terms and what you will need to carry it out. Firstly you will need to sign up for an exchange that has the ability to short Bitcoin and has futures contracts. We recommend either BitMEX or FTX.

The Basics of Futures Contracts

Now lets run through the basics of futures. A futures contract is an agreement to buy or sell a particular asset at a predetermined price at a specified time in the future. For example on BitMEX there is a futures contract named XBTZ19. This is a contract to buy Bitcoin on the 27th of December 2019. If you have an exchange in front of you, you will notice that the futures price of Bitcoin is different than the regular price. You would be right to ask why this is? I will bring you back to what a futures contract is. An agreement to buy an asset at some point in the future, not now. So when traders trade futures they are trading based on what they expect the price of their chosen asset to be at some point in the future.

This brings us on to the concept of backwardation and contango. Backwardation is the market condition wherein the price of a commodities forward or futures contract is trading below the expected spot price at contract maturity. Essentially the price of the asset in the future is expected to be less than the price today. Contango is a situation where the futures price of a commodity is higher than the anticipated spot price at maturity of the futures contract. Meaning the price of the asset in the future is expected to be more than the price today. Another essential point to note is that the futures price of an asset will always return to the assets spot price. It is here where our opportunity lies.

Futures Contango and Backwardation Always Return to the Spot Price

Applying The Strategy

Now that we have established the basics of futures contracts how do we exploit them? It is actually very easy. It is best shown by means of example. if today’s price of Bitcoin is 10000$ and the futures price for December is 10300$ we can simply take 50% of our position buy today’s price of Bitcoin and short Decembers price of Bitcoin. (The same method is true for the inverse. If the futures price is less than today’s price. We buy futures contracts and short the spot price.)

The December futures will eventually reach the spot price as previously mentioned. So we make 300$ (10300$ – 10000$ = 300$) completely risk free. Since technically we have zero exposure. 50% buy – 50% sell = 0% exposure. Yet we are guaranteed 300$ as long as we hold to expiry. The same method is true for the inverse. If the futures price is less than today’s price. We buy futures contracts and short the spot price.

But that’s not all. It is possible for the futures contract to flip from contango to backwardation or vice versa. Meaning we can make more than the arbitrage before it even expires. This happened only recently with Bitcoin as well. Notice two red vertical lines on the chart below where it occurred.

Bitcoin Chart Showing Previous Situations Where Futures Flipped From Contango to Backwardation
Futures Flipping From Contango to Backwardation

Conclusion

In summary. Futures arbitrage is something I believe that every trader should have in his tool belt. It is quite simple and easy to carry out once you first wrap your head around the basics of future contracts. It allows traders to hedge their bets while still having receiving a reward at the end of it. Nobody can say no to essentially risk free returns for doing nothing