Analysis & Opinions

Market-Neutral Derivatives Trading, Explained by CMC

In this post, we seek to explore the topic of “Market-Neutral Crypto Derivatives Trading”. There has been a slew of derivatives exchanges launching in the last couple of years, many offering Perpetual Swaps and Futures. This post will be a guide for anyone interested in trading Crypto-Derivatives without needing to have a directional bias. The post will be broken down into three segments. We will first help you understand what derivatives are and what makes crypto derivatives special. Next, we discuss the BTC curve and the different products that make up the curve. Lastly, we will be talking about how to execute the strategies discussed! 

Gerald, our Head of Research, presented these slides on September 12, 2019 at Consensus, Invest:Asia. We have reproduced them and have provided commentary to help everyone understand the concepts presented.

Before we begin, just a customary disclaimer message that this is not investment advice. Please do your research and due diligence before you invest in anything!

Understanding Derivatives

So, we begin by understanding “Derivatives”. What are they? Well, they are financial instruments whose value is “derived” from an underlying asset(s). These underlying assets could be anything ranging from foreign exchange rates, commodities or even cryptocurrencies.

Examples of derivatives include Swaps, Futures, Options, Warrants, and so on. Essentially, you could classify anything that isn’t a spot instrument, as a derivative!

So, why do they exist? Derivatives are used as a tool to hedge, to speculate, and to price metrics like volatility and interest rates.

So, what are the differences between Futures (Derivatives) trading in the traditional markets versus that in the crypto markets? Shown above on the left picture is a spread chart of EURUSD spot against its futures. (A spread chart charts the pricing difference between the 2 products. In this case, its Spot EURUSD versus Futures for the Euro.)

On the right picture, we see the spread of BitMEX’s perpetual swap against OKEx’s quarterly contract. It looks extremely wild and unorganised, and very different from the chart on the left. Why is this so? This is due to the phenomenon we like to call “Decentralised Interest Rates”…

Typically, the ECB and the Fed Central Bank sets interest rates for fiat currencies like the Euro or USD, making the overnight interest rates extremely stable.

However, in the crypto sphere, there is no “centralized authority” or “central bank” for Bitcoin. Lacking a central authority fixing overnight rates makes the interest rates entirely dependant on the supply and demand of the market, resulting in extreme volatility. Additionally, in crypto we have access to crazy leverages while trading crypto-derivatives, such as BitMEX’s 100x and OKEx’s 20x. Add that to the wild volatility you see in the spreads, and that is precisely what makes trading market neutral crypto derivatives so exciting. 

Visualizing the Curve

The BTC curve shows the various products, across varying expiry durations, currently offered by the crypto exchanges in the space. The Spot market is an important piece of the puzzle, with exchanges such as Coinbase, Bitstamp, Kraken and Gemini commonly being used as components when pricing the BTC Index. This BTC Index is used to price all cash-settled derivatives in the space.

Next, we have the Perpetuals; a group is growing at a very fast pace. Exchanges like BitMEX, Deribiti, OKEx and many other exchanges are launching their spin on Perpetual Swaps.

Lastly, we have different duration futures, ranging from 1 week to quarterly. Duration futures with higher liquidity are those found on Huobi and OKEx as well as regulated exchanges such as CME.

Reading and understanding Contract Specifications of a derivative is key in making sure you understand the product that you are trading.

Delivery Mechanism the way the contract is settled and delivered. You’ll need to know whether its cash-settled or whether it involves a physical delivery. Cash-settled products rely on a BTC Index for pricing while physical delivery products involve the transfer of assets between the involved parties (think Bakkt).

Index Components of every exchange may vary. So please be aware which spot exchanges/market pair the derivative is using!

The Currency Denomination of the futures contract defines the profit and loss settlement currency of the contract. Most products in the space are either BTC or USD denominated. Currency denomination will also usually define whether it is an inverse futures or a vanilla one.

Lastly, there might be deviations in timings for delivery, even though the futures expire on the same day. An example would be OKEx and BitMEX futures expiring at different times of the same day – OKEx’s expires on 04:00 EDT while BitMEX’s expires at 08:00 EDT.

The two most popular products in the space are the Perpetual Swaps and Futures. We will now discuss the mechanics behind them and how they are differently priced.

Perpetual Swaps have no delivery date and is designed to be closely priced to spot. The periodic funding swap achieves that by incentivising traders to price the swap as close as possible to the BTC index. How does this work?

When the swap is trading at a premium to the BTC index, Longs pay funding to Shorts. This incentivises traders to go short on the Perpetual, thereby pushing the swap downwards to converge with the BTC index.

The converse also holds. When the swap is at a discount, Shorts pay funding to Longs, and traders are incentivised to go long, thereby pushing the swap upwards towards the BTC index.

As for Futures, when its contract expires at the delivery/ settlement date, its price would converge with that of the spot. Up until that point, the price of the futures can freely fluctuate with no consequences. Generally, the further away the delivery date, the more volatile the price of the futures.

Knowing how the two main products in the space works, we can now go on to discuss the construction of the different spreads with the whole range of products.

Vertical Spreads” comprise of similarly constructed instruments – i.e. Perpetuals vs Perpetuals. Vertical spreads refer to similar products listed on different exchanges, like BitMEX’s Perpetual Swap vs Deribit’s Perpetual Swap. 

Horizontal Spreads” involves trading the spread of contracts with different settlement dates. Some examples include – Perpetual vs 1-Week Futures, Perpetual vs 3-Month Futures or 1-Week Futures vs 3-Month Futures. Due to the different delivery dates, horizontal spreads are more difficult to trade.

Having so many different spreads to choose from, we need to find the best ones to trade! We have come up with a framework to evaluate the spreads you are trading, which we call “The Holy Trinity”. 

The Holy Trinity comprises of 3 factors, namely the “Cost of Execution”, “Risk of Volatility” and “Ease of Execution”. These 3 factors are in constant conflict with one another, making it difficult to attain all 3 factors to a large degree. 

On the left chart, we see a vertical spread of 2 spot exchanges, Coinbase vs Bitstamp. The “risk of volatility” is extremely low, as it is rare for the prices to greatly diverge as many traders are constantly exploiting the pricing discrepancy. This keeps the spreads extremely tight. Commissions paid to execute this trade may even be more than the possible profits from trading this spread. Therefore, this strategy scores high on “Risk of Volatility”, but low on both “Ease of Execution” and “Cost of Execution”.

On the right chart, we see a horizontal spread of a Perpetual Swap against a 3-Month Future. While the risk of volatility is a lot higher, it would be a lot easier to execute this spread as there is less competition for any given price. The commissions paid to execute the trade will also be relatively cheaper, as the potential profit of the trade is greater. This strategy scores low on “Risk of Volatility”, but high on both “Ease of Execution” and “Cost of Execution”. Therefore, while this may be a riskier trade, it may be an overall more profitable trade as compared to the vertical spread trade above.

It is extremely rare to find a spread trade that fulfils all 3 factors in this trinity. Finding one is thus considered to be the “holy grail” in trading.

Now, we move on to the single, most important consideration every trader should be aware of before trading – “Risks”. Here, we seek to understand the risks involved when executing a trade.

There are 3 types of risks involved in the strategies we discussed above, namely Liquidation Risk, Inventory Risk and Delta Hedging Risk.

Liquidation Risk refers to the liquidation price – the price at which your position must remain above to avoid being liquidated to meet capital requirements – of your position on any given exchange. Most strategies require 2 exchanges to execute, resulting in you having a leveraged position on both exchanges that comes with corresponding liquidation prices. For example, going Long on a BitMEX Perpetual Swap and going Short on an OKEx Quarterly Futures would result in having 2 naked positions on each exchange. While the entire portfolio may be market neutral, these 2 standalone positions aren’t and are subject to liquidation risk.

Inventory Risk refers to the amount of spread inventory the portfolio has and is subject to spread volatility. If the spread is trading at a price that is lower than the price you sold at, you would be underwater, and your portfolio would be drawn down. Exchanges, in general, allow high leverages. Traders need to ensure that the amount of inventory they are holding is at a comfortable level and not run the risk of being overly leveraged.

Delta Hedging Risk refers to ensuring that your portfolio is market-neutral at all times. When a maker bid enters the market and gets filled, a corresponding offer should be placed and filled, to ensure that the portfolio is always market neutral. Having an order filled and not hedged could result in undesired consequences as we are running a market-neutral portfolio.

Executing the Trade

Mean Reversion Trading refers to holding a position in the futures to delivery and converging the spread between Futures and Index. For example, consider a scenario where the Futures is at a premium to the Perpetuals. In this scenario, we would bank on the fact that the two will converge at delivery, and perform a mean reversion trade by selling the futures and buying the Perpetuals. This trade usually involves paying some funding on the position of the perpetual.

Directional Spreading refers to the opposite, in which you’re betting on further divergence occurring before the settlement date. This trade is an advanced way of executing spreads as greater divergence, unlike convergence at settlement date, is not guaranteed. The rewards of getting this trade right is 2-fold, as you would receive funding on the perpetual and also profit from the divergence. 

In the diagram above, the red line illustrates the spread’s historical price and up to the current point in time, “?”. At this juncture, there are 2 possible routes you could take: either mean revert the spread, or bet that the spread diverges further. 

Now that we’ve looked into opportunities in the realm of derivatives let’s look at some opportunities in the spot borrowing and lending markets!

Consider a scenario where the futures are trading at a premium to spot. To realise this arbitrage, you would have to borrow USD (if rates are favourable), buy BTC and short the futures. Once the position is in, you’d then have to wait for the delivery date to cover the futures, sell the BTC and repay the USD loan with accrued interest. If the interest on the loan is less than the premium of the futures, you will make a profit.

The converse scenario also holds. If the futures is trading at a discount, you would borrow BTC, sell the BTC and go long on the futures. You’d then wait for the delivery date to buy back BTC and repay the loan. 

Interest rates in the spot market are relevant to the pricing of futures in the derivatives space and as they belong in the same financial ecosystem. Opportunities exist anywhere on the curve, and it is up to the trader to discover and to exploit them.

Let’s recap! Here are the four key points to remember for trade strategy execution:

  1. Liquidation Risk – Always be mindful of your liquidation price of any position you have on any exchange. Getting REKT-ed (liquidated) is the worst thing that can happen to a trader, so you’ve got to make sure that never happens. 
  2. Execution Risk – Be aware of your execution costs (or commissions). Costs can add up, and they will eat into your bottom line.
  3. Execution Efficiency – Be aware of the level of competition in the spreads that you trade, so that you can design your execution algorithms to ensure you get the better fills. For instance, many crypto exchanges offer rebates for “Maker” orders, so do design your algorithms to capitalise on rebates and cheap “Taker” fees. Optimising these parameters is key to success in spread trading.
  4. Inventory Risk – Be aware of the inventory you are holding, and be aware of the potential drawdowns that might occur due to volatility spikes.

To conclude, are four key takeaways to Market-Neutral Derivatives Trading:

  1. Trading crypto derivatives doesn’t have to be directional. Designing and executing market-neutral spreads can be extremely fun and rewarding.
  2. Trading market-neutral spreads doesn’t mean it’s risk-free. There are underlying risks involved in executing these spreads, and you need to be aware of them
  3. The crypto markets will continue to mature, and we will be seeing new products and exchanges launching shortly. These new products would make the entire ecosystem vibrant, and it should result in more possibilities.
  4. In our decentralised crypto sphere, where there is no central bank to fix rates, market neutral strategies will always be interesting!

Gerald is the Head of Research at CoinMarketCap. He started his career as a professional derivatives trader in the traditional markets, trading bond and commodities futures. He saw the trading opportunities that existed in Bitcoin Futures and Swaps and co-founded Hashtag Capital, a BTC-based hedge fund in 2018. Hashtag Capital was subsequently acquired by CoinMarketCap in mid 2019.

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