[Deribit] Cash And Carry Trades

In this lesson we will detail what a cash and carry trade is, and how a trader can use one to capture the difference between the spot price and the futures price of bitcoin. This type of trade is often referred to as basis trading.

If you have ever traded futures contracts, you will no doubt have noticed that they tend to trade at a slightly different price than spot markets. Although it is possible for the futures price to trade below the spot price (also known as backwardation), it is far more common for the futures to be trading at a price higher than the spot price (also known as contango). When the market is in contango, it is possible for a trader to capture this premium on the futures contract by executing a cash and carry trade.

In a cash and carry trade the trader will purchase the underlying asset (e.g. bitcoin) in a spot market. They will then short the same asset using a dated futures contract that is currently trading at a premium. This corresponding short position means there is no exposure to price movements in the underlying asset. All the trader then needs to do is wait for the difference between the spot price and futures price to decrease.

Why does this trade make a profit? 

The big advantage the trader has when executing a cash and carry trade is the knowledge that the futures contract has a fixed expiry date, at which time the futures contract will be settled using the spot price (or some index that is an average of spot prices). So they know that by the expiry date at the latest, the premium of the futures contract will reach zero.

No trader can know for sure exactly what the price of an asset will be on any given date in the future, but they do know that the difference between the spot price and the futures price will tend towards zero as the time to expiry approaches zero. In fact it’s not uncommon for it to reach zero or close to it well before the expiry date, allowing the trader to book the profit early. More on that later.

The following chart displays the percentage premium of the Deribit December 2019 bitcoin futures contract (BTC-27DEC19) over spot prices. This chart shows the 6 months leading up to 27th December 2019, which is when the contract expired.

As you can see the premium moves around quite a bit over the life of the contract, but clearly tends towards zero as the days to expiry decreases. This is a very typical looking futures premium chart for bitcoin, so if you study other futures dates you will see similar behaviour.

The aim of a cash and carry trade is to open the trade when there is a nice premium on the futures contract (the peaks on the chart), wait until the premium decreases to zero, and then close it. In doing so, the trader will have captured the premium while never being exposed to price movements of the asset itself.

A practical example 

At time of writing, the BTC spot price on Coinbase was trading at around $8,800 while the June futures contract on Deribit was trading at around $9,190.

As you can see on the chart this results in a dollar premium of about $390 and a percentage premium of about 4.4%.

You can learn how to create these charts in this Deribit blog post.

So let’s look at an example of how to capture that premium.

The execution of a cash and carry trade is relatively simple but involves two separate transactions.

1) Purchase the underlying asset.
2) Short a futures contract for the same asset.

Here the trader purchases 1 bitcoin for $8,800 on the spot exchange. They then short the June futures contract on Deribit with a position size of 1 bitcoin, which on the June futures contract is $9,190.

All that remains is to wait for the difference between these two prices to decrease, then the trade can be closed for a profit. It doesn’t matter whether the underlying price goes up or down overall, just that the difference between the future price and spot price decreases.

Let’s assume the trader has waited a few weeks since opening the position, and the premium has now reduced to zero i.e. the June future price equals the spot price. The following chart displays the total value of the trader’s funds at the end of this trade in both USD and BTC, depending on what the underlying price of bitcoin is when the trade is closed.

The trader initially used their $8,800 to purchase 1 BTC. They then used this 1 BTC as collateral to open a short on the Deribit June future. As you can see on the chart, this results in the amount of BTC the trader has at the end of the trade varying according to where the price of bitcoin moves. If the price moves down, the short position will of course make a profit, and if the price moves up the short will make a loss.

Notice though that the total value when measured in USD is always $9,190 no matter where the price moves.

For example, if by the time the trader closes the positions, the BTC price is $5,000, then the futures short will have made a profit of 0.838 BTC (formula included below) resulting in a total balance of 1.838 BTC. As the BTC price is now $5,000, the trader can sell this 1.838 BTC for $9,190. This is calculated as 5000 * 1.838 = 9190.

If instead the BTC price had risen to $10,000 before the premium reaches zero, then the futures short will have made a loss of 0.081 BTC, resulting in a total balance of 0.919 BTC. As the BTC price is now $10,000, the trader can sell this 0.919 BTC for $9,190. This is calculated as 10000 * 0.919 = 9190.

PNL in BTC for the futures short can be calculated as:

(Entry Price / Exit Price -1) x Position Size in BTC

When we say close the cash and carry position, what exactly do we mean? 

To open the trade, the trader used USD to purchase BTC, and they also shorted the BTC futures contract. Closing this position then, involves buying back the futures position, and selling all the remaining BTC back into USD.

In this example, the trader was short the futures contract on Deribit with a position size of $9,190, so they close this leg of the position by buying $9,190 of the same futures contract, reducing their position to zero.

Then they sell all the remaining BTC back into USD on a spot exchange. As we showed previously, as long as they close the cash and carry when the futures premium is at zero, the BTC will be worth exactly $9,190.

The trader began with $8,800, and no matter what price BTC moved to over the course of the trade, they are left with $9,190 at the end of it. They have therefore successfully captured the $390 premium, all while taking no directional risk.

Some things to note about cash and carry trades 

There is very little risk involved in this kind of trade. Although you have purchased the asset, your short completely hedges this long exposure, so you’re not exposed to price movements. However, it’s worth bearing in mind that you do have at least some of your funds stored on an exchange to use as collateral for the futures short, so you do have some counterparty risk.

This is where leverage comes in handy. By utilising the leverage available you do not need to move 100% of the BTC onto Deribit to use as collateral for the futures short. You can store whatever you’re not using as collateral for the futures position in your own wallet. That does not mean it’s a good idea to open the short position using the maximum leverage available though, because you don’t want the liquidation price of your short to be too close to the current price.

The higher the percentage of your funds you keep on the exchange as collateral for the short, the higher your liquidation price will be. At the extreme if you place 100% of the funds on the exchange, you will have no liquidation price. For more on this see our lesson on “Hedging USD Value By Shorting 1x” here.

Placing just 33% of the funds on the exchange will still give you a liquidation price 50% higher than the current price. This should be plenty of room to give you time to deposit more of the funds if it becomes necessary, without having to have all your funds in someone else’s possession.

When to close a cash and carry trade 

In our example the trader waited until the premium reached precisely zero, and indeed this is the simplest and most common way to execute these trades. This will happen at expiry regardless, but it is often not necessary to hold the position into expiry. Sometimes the premium of the futures contract over the spot price will move down to zero (or close to it) well before the expiry date, and even become negative on occasion, giving the opportunity for extra profit.

When the premium reaches zero well before expiry, the trader can close just as they would at expiry. Buy back the futures position and sell all the remaining BTC into USD.

When the futures premium becomes negative, this means the futures contract is trading at a discount i.e. the futures price is lower than the spot price. If a trader still has a cash and carry trade open, this is the perfect time to close it!

A great example of this occurred on 24th September 2019. The following is the price action (based on the close of 15 minute candles) of the Deribit December 2019 bitcoin futures contract (BTC-27DEC19) and the Deribit BTC-Perpetual.

As you can see, earlier in the day the futures contract was trading at a higher price, as usual. At a little after half past six the price of both instruments began to drop fast. Importantly for any traders with cash and carry trades already on, the futures price dropped several percent further than the perpetual and spot prices. This resulted in the following percentage premium/discount during that same time period:

This discount on the futures contract lasted quite a while, and so presented the perfect opportunity for any traders who were still in any cash and carry trades, to close them three months before the contract expired, and for several percent extra if timed well.

This type of quick change in the premium will typically happen when the price drops far and fast. You may wish to set alerts that let you know when this type of price action is occurring.

Rolling forward vs closing 

We mentioned earlier that to close the trade, you buy back the futures short position then sell all the remaining BTC back into USD. It’s worth mentioning though that if there is already another attractive cash and carry trade available on the next futures contract, you can instead skip out the selling it back into USD step, and open a new short on the next futures contract instead.

As the trading fees on derivatives exchanges tend to be lower than that of spot exchanges, and you will also avoid having to do any transfers/withdrawals, rolling the position to the next month will often work out cheaper than closing the position entirely.

Whether rolling it forward is attractive or not, will of course depend on what sort of percentage is available on the available futures contracts when you wish to close the current trade. You will also have to decide whether you want to tie up your funds for another few weeks or months.

Extra thoughts on cash and carry trades 

This type of trade is capital intensive as you’re not using leverage (except to minimise counterparty risk), and the percentages you’re likely to make are far smaller than if you had instead made a correct prediction on price direction over the same time period.
The trade off being that you can’t be ‘wrong’ about a cash and carry trade. The futures premium will eventually close even if you have to wait until expiry for it to happen. So in comparison it is an extremely low risk trade.

You’re effectively earning a few percent interest on your funds for the life of the trade, so to consider if the trade is worth it for you, you must consider the opportunity cost of having your capital tied up. For example, if you spot a cash and carry trade that is offering a 2% premium but the time to expiry is 9 months, you may be able to beat this by putting your capital to better use somewhere else.

We mentioned earlier how it wasn’t necessary to keep 100% of the funds on the exchange where you’re shorting the future. Using leverage allows you to keep the rest of the funds somewhere else, for example on a hardware wallet like Trezor or Ledger. It is far preferable to keep the funds in your own wallet because you are in complete control of it at all times, and should you need to deposit any more of the funds to the exchange, you don’t have to wait for another exchange’s withdrawal processing times.

When using leverage, there is also a reason why Deribit specifically is a great platform to place this type of trade, and that is the trading bandwidth limits that Deribit uses. In short, the trading bandwidth limits stop any trades that are outside a certain percentage band around the mark price from executing. This greatly reduces the severity of any temporary spikes like liquidation or stop loss cascades, as it stops them from moving more than a certain distance from the mark price.

Not every exchange has this type of feature, and those that don’t represent a riskier proposition for using leverage. For example if your liquidation price is 50% above the current price, and you know the current trading bandwidth limit for the future on Deribit is say +/-8%, you know your position is safe even if there is a liquidation cascade on Deribit. As mentioned earlier though, this doesn’t mean using the absolute maximum leverage possible is wise. Give yourself some wiggle room.

Summary 

Cash and carry trades are very simple, low risk trades, so as you would expect they usually offer relatively low percentage gains. However, while they are capital intensive, they are not time or effort intensive. With the help of alerts (or automation), you could spend as little as an hour per quarter actually executing this trade and still make a reasonable return, leaving you with plenty of time to spend doing other productive activities.

So if you tend to have any funds sitting around in fiat or stable coins for any length of time, you should consider adding cash and carry trades to your repertoire.