Basis Trading – Mind the Gap

Introduction

When you plan to trade cryptocurrencies, you come across various options with varying risk portfolios. Spot trading is just like buying or selling any commodity. It means you buy and then hold the asset to sell it at a higher price. Futures trading is riskier as it is based on speculation. You bet on the price movement and can earn a profit if the movement goes in your favour or incur loss if the asset goes against your expectations. Arbitrage trading exploits the gap between the price of a coin on one exchange and that on another.

What is Basis Trading?

Basis trading, on the other hand, focuses on the price difference between the spot and futures markets of the same cryptocurrency. In fact, “basis” is the difference between the price of a coin in spot market and the price in futures. Instead of betting on the direction of the market, traders aim to profit from the spread between the current spot price and the price of a futures contract. This strategy is generally less affected by market swings, as gains and losses in one position are balanced by the other. By carefully timing entry and managing costs, basis trading allows investors to potentially capture steady returns from price convergence over time.

The concept of basis trading is not limited to the cryptocurrency market. It has been applied over the decades in the traditional markets. For example, in the commodities market, traders have long used basis trading with assets like gold, oil, and wheat, buying the physical commodity while simultaneously selling futures contracts to lock in the price difference. Similarly, in bond markets, investors exploit the gap between the cash price of a bond and its corresponding futures contract to secure predictable profits, demonstrating that basis trading is a versatile strategy across financial markets.

How Basis Trading Works

To carry out basis trading, a trader simultaneously takes positions in both the spot and futures markets of the same asset. Typically, this involves buying the asset in the spot market while selling a corresponding futures contract when futures trade at a higher price. It also includes doing the reverse if futures market is trading at a discounted price. The profit is realized as the futures price converges with the spot price at contract expiry. Successful basis trading requires careful monitoring of the basis (the price gap), attention to trading fees, funding or borrowing costs, and the timing of entry and exit, as these factors directly affect net returns.

Note that there is no dedicated option for basis trading on any exchange. This is a kind of strategy to hedge your position in one trade by taking the opposite position in another. You can do it manually by combining spot and futures positions, carefully selecting contracts with the desired expiry dates. Although it reduces exposure to market volatility, it still requires attention to trading fees, funding costs, and liquidity to ensure that the expected profit from the basis is not eroded.

A Case from Real Market

Let’s suppose $ETH is trading at $4,600 in the spot market, whereas a three-month futures contract is priced at $4,650, a trader could buy $ETH on the spot market and simultaneously sell the same amount in the futures market. The basis, in this case, is $50, representing the premium, or higher price, of the futures price over spot. By executing a cash-and-carry strategy, the trader aims to capture this gap. They purchase $ETH at $4,600 and sell the futures contract at $4,650. If the spot and futures prices converge as expected at the contract’s expiry, the trader can use the $ETH bought in the spot market to fulfill the futures position and can earn a profit of $50 per ETH, subtracting any trading fees and operational costs.

Types of Basis Trading

Basis trading can be categorized into two types, depending on the trader’s view of the market. A long basis trade is executed in a contango market, when the trader expects the spot price to rise relative to the futures price, typically by buying the asset in the spot market while selling a futures contract.

Conversely, a short basis trade is used in backwardation, when the trader anticipates that the spot price will fall or that the futures price will increase faster, achieved by selling the asset in the spot market while taking a long position in futures. In both cases, traders rely on a combination of market trends, historical patterns, and economic indicators to guide their decisions and manage risk effectively.

Significance of Basis Trading

Basis trading is valuable for both hedgers and speculators in the cryptocurrency market. Hedgers use it to reduce the risk of price volatility. For example, an investor who holds a large amount of $BTC can trade on a predictable outcome by taking offsetting positions in spot and futures markets. Speculators, on the other hand, aim to profit from fluctuations in the basis. The analysis of trends and market activity enables them to anticipate how the spread between spot and futures prices will move.

Risks Associated with Basis Trading

Basis trading carries several risks and challenges that traders must manage carefully. One major concern is basis risk, which occurs when the spot and futures prices do not move as anticipated. It results in reduced profit or even loss.

Another challenge is market liquidity. In thin or highly volatile markets, it can be difficult to enter or exit positions at desired prices due to an increased the risk of slippage.

Additionally, basis trading is inherently complex as it requires a solid understanding of market dynamics, careful trend analysis, and effective risk management. For beginners, this combination of factors can be overwhelming, making it essential to approach the strategy with knowledge and caution.

Summarily, basis is the difference between a coin’s spot price and futures price. Traders expect the prices to converge at one point at the end of the contract that they choose. Basis trading can be of long type and short type just like normal futures trading. On the face value it seems a case where you can only be in profit, but it is not without its risks. With proper knowledge and homework, you can nail it like any other type of trade.