Arbitrage Opportunities in Crypto Futures: How to Profit from Price Differences
Futures trading is the act of trading futures contracts which allows certain crypto assets to be traded at a predetermined future price. Futures contracts derive their value from their underlying assets. However, like the Spot markets, “buy low and sell high” is regularly the most used strategy in the futures market, but since you can also short-sell very easily in the futures market, a “sell high and buy low” approach is often used as well.
Arbitrage trading prospects arise when the value of a security differs from that of a comparable cryptocurrency asset on another exchange or market. For instance, a surge in the price of Ether Futures due to news may not have been reflected in the pricing of all available call options for the asset. In such cases, a trader can sell the overpriced asset and buy the underpriced options to earn a risk-free profit equal to the difference between the selling and buying prices.
What is Arbitrage Trading?
Arbitrage has been a time-honored trading strategy in traditional financial markets well before the inception of the crypto market. However, there is currently more buzz surrounding the possibility of lucrative arbitrage opportunities within the cryptocurrency industry.
Arbitrage provides traders with unique opportunities to profit from price discrepancies in securities, particularly in the stock market. For instance, you can purchase an asset on the LBank exchange for $10 and sell it on another exchange for $11, locking in a profit of $1.
Arbitrage involves purchasing and selling identical or similar assets in two different markets at different prices that provide an advantage. The term “similar” should be understood broadly, as the arbitrage may involve several derivatives. Two essential features of these transactions are highlighted by this definition.
Firstly, the trades on different assets must occur simultaneously. This is because arbitrage opportunities must be as close to risk-free as possible and are typically short-lived. Secondly, the assets should be the same or highly correlated/co-integrated. This can be bitcoin and ethereum, one can go further and include assets that behave similarly but are not exactly the same. This similarity serves as a hedge and eliminates all risks beyond the actual execution.
Arbitrage trading gained popularity in the 1980s, with many investment banks and hedge funds hiring mathematicians and computer scientists to develop arbitrage trading models for their proprietary desks. Arbitrage traders play a crucial role in making markets more efficient. If assets are correctly valued and similar, arbitrage opportunities should ultimately converge. This convergence could be a known event, such as the expiration of a futures contract at a predetermined date.
Different Arbitrage Trading Strategies
There are various methods that crypto arbitrageurs can use to benefit from market inefficiencies. These include:
Basis trading
This is a futures trading strategy that focuses on the difference between the spot price of a commodity and the price of a futures contract for that same commodity. This price difference is called the basis. Traders initiate “long the basis” trades when they anticipate the basis to increase, and “short the basis” trades when they expect the basis to decrease. The main objective of basis trading is to capitalize on the expected change in the basis to generate profits.
Statistical arbitrage
Statistical arbitrage is a powerful technique that integrates econometric, statistical, and computational approaches to facilitate large-scale arbitrage trades. Traders who utilize this method often rely on advanced mathematical models and trading bots to execute high-frequency trades and maximize profits. Trading bots are automated systems that can execute a vast number of trades at exceptional speeds, leveraging pre-established trading strategies to take advantage of market inefficiencies.
Triangular arbitrage
This is a crypto arbitrage strategy that involves trading the price difference between three different cryptocurrencies on one exchange. It’s possible to identify undervalued cryptocurrencies on the exchange and take advantage of arbitrage opportunities by selling one cryptocurrency for another, then using that cryptocurrency to buy the third, and finally buying back the initial cryptocurrency with the third. If executed correctly, this strategy can result in a profit in the form of more of the initial cryptocurrency than at the start. Since all the transactions take place on one exchange, transfer fees are not an issue.
Spread Arbitrage
Also known as “Calendar Spread Arbitrage,” is a common hedging technique used to generate profits by taking advantage of the difference in prices between two different expiration contracts of the same asset. This is possible because Delivery Futures contracts converge with Spot prices at expiration dates, allowing you to anticipate trends in Delivery Futures prices and profit from the spread between Spot and Futures contracts with different expiries. This involves taking two opposite positions on contracts with different expiries (spot-futures or futures-futures) while collecting their spread at a given time in a delta-neutral strategy.
How to Profit from Price Differences — Real Example
Let’s say we have 15,000 USDT and Bitcoin’s price is at 12,000 USDT. Here’s how we’ll approach spot-futures arbitrage:
First, we’ll transfer 7,500 USDT to our futures account and another 7,500 USDT to our trading account. Next, we’ll buy 0.625 BTC (worth 7,500 USDT) in the spot market and short 0.625 BTC in the perpetual futures market with the remaining 7,500 USDT.
Assuming the current funding rate is 0.03%, we’ll receive 2.25 USDT just before the charges. To calculate the annual percentage rate (APR) for this, we can receive the funding fee thrice a day, which amounts to 24.975% APR (2.25 x 3 x 365 = 2463.75 USDT; 2463.75 / 15000 x 100% = 16.425%).
To increase our annualized return, we can leverage our short position in the perpetual futures market. By using 2.5x leverage, we can buy 0.78125 BTC with 9,375 USDT while shorting 0.78125 BTC with 4,687.5 USDT. This way, we’ll receive 31.125% more funding fee (3.7125 USDT) compared to using 1x leverage (0.78125 x 12000 x 0.03% = 2.8125 USDT).
Apart from using higher leverage and searching for coins with higher funding rates, it’s also important to consider the price difference between the futures price and index price to maximize our profits.
Final Note
Overall, Arbitrage is a powerful tool in the alternative investment arsenal that can provide investors with low-risk returns. However, it requires high transaction volumes to be effective, since the yield is usually small.
Disclaimer: The opinions expressed in this blog are solely those of the writer and not of this platform.
