DeCommas 101 - Basis trading explained
TL;DR: Basis Trading is a financial arbitrage trading strategy, which benefits from the basis – the difference between the spot price of an asset and the price of a derivative, based on the underlying asset. When a trader expects that difference to grow in the future, they “long the basis”; otherwise the trader “shorts the basis”. Basis trading is a common strategy when producers look to hedge the cost of production against the anticipated sale of the commodity they are producing. However, this strategy is also becoming common in crypto, but instead of dated futures, crypto traders use perpetual futures which have no expiration date and their price is regulated with a special mechanism called funding.
What is Basis Trading?
Basis trading refers to a situation where an investor believes that two instruments (an underlying asset and a derivative) are mispriced relative to one another and that the wrong price will correct itself, so that a profit on one side of the trade more than compensates for a loss on the other side of the trade. That is, the trader earns on the change in the difference between the spot price and the price of the derivative (for example, futures) by its expiration date.
To understand the context, let’s recall the concept of arbitrage. Arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset’s listed price. Arbitrage exists as a result of market inefficiencies and it both exploits those inefficiencies and resolves them. In the case of basis trading, arbitrage also takes place, only the asset and its derivative act as the trader’s instruments.
There are two sides to the deal. The first one – trader shorts the basis, i.e. they expect the difference between a derivative and an underlying asset price to decrease. In this case, they sell an asset at spot price higher than the price of futures, which they buy (for the same underlying asset). The second one – trader longs the basis, that is, they expect to increase the difference.
In general, the whole point of Basis Trading is an attempt to profit from the expected direction of asset price. The basis, in futures trading, is not to be confused with the terms “basis price” or “cost basis” which are unrelated to the context of basis trading. Everything described above looks complicated at first glance, but basis trading strategy is more understandable when explained based on practical examples.
Basis Trading in Practice
In practice, Basis Trading is very often resorted to in sectors of commodity production which can have a noticeable change in value by the end of the production cycle. For example, a corn farmer who grows corn notices very favorable weather conditions and lower fertilizer prices two months before harvesting and selling the crop. In such a situation, there may be an oversupply of corn on the market.
Because of the oversupply, the price of the commodity will fall, consequently, the farmer’s profit will be less than expected. In this case the farmer sells futures contracts for the amount of corn, expected to sell at the time of harvest. If the spot price of the commodity is $4.00 per bushel and two month futures are trading at $4.25 per bushel, then the farmer could now lock in a price with +.25 cent basis. The farmer thus shorts the basis expecting the difference between the spot price and the futures price to decrease.
Shorting in this case gives the farmer an opportunity to hedge against a future decline in price. Traders on the other side of this deal buy futures and sell contracts with a shorter expiration date. In this way the transaction is hedged, i.e., profit is protected from corn price fluctuations. They long the basis, i.e. they expect the difference between the spot and the futures to grow in the future.
Basis trading is common not only in the agricultural industry, but also in other areas – precious metals, stocks and even cryptocurrencies. The variables that affect all of these assets may be different, but the bottom line remains the same – an opportunity to benefit when the basis amount increases or decreases. You should understand that the concept of basis trading is based not on supply and demand, but on expectations of asset price changes. Those who trade in basis trading are ultimately constantly trying to anticipate changes in the expectations in speculators and hedgers.
Basis Trading in Crypto
Basis trading strategy can be performed both with dated futures (as shown in the example above) and perpetual futures. Let’s start with the first option. Dated futures on cryptocurrency are very often traded above the spot price (also known as contango), although it is possible for the futures price to trade below the spot price (also known as backwardation).
In a cash and carry trade the trader will look for a way to make a profit on a contango by buying BTC on the spot and selling the same amount of futures contracts. In this way they will not have exposure to price movements, in other words the strategy is delta-neutral. Knowing the expiration date, a trader can get profit by shorting the basis, because by the expiration date spot and futures prices will converge.
Spot and futures prices will converge on expiration date due to arbitrage. The two can even converge to the same price before the expiration date, giving earlier potential profits if a trader immediately buys back the futures and sells the spot to close his position.
Now let’s talk about perpetual futures, which are the backbone of many DeCommas strategies of basis trading in DeFi. Perpetual futures have no expiration date. Instead their price formation mechanism is regulated by the concept of funding. Funding payments are periodic payments of longs to shorts and vice versa depending on market conditions. When funding is positive, longs pay shorts, when funding is negative, the opposite is true. For instance, on FTX, positive funding means that the perpetual contract’s price is greater than the mark price.
In the case of perpetual futures, the trader can make a profit with a delta-neutral strategy to collect funding fees. This mechanism is available on decentralized exchanges (e.g., Perpetual Protocol), with which DeCommas strategies work.
Example: in a trading pair on Perpetual Protocol there is a relatively high positive funding rate, which can generate a high APR. The trader opens a short on perpetual futures and buys the same coin on the spot for the same volume. They remain delta-neutral - fluctuations in the price of underlying assets generate neither profit nor loss. But they receive funding payments – the higher the funding fees, the higher APR can be generated by this strategy.
You may be asking yourself – it’s pretty inconvenient and time-consuming! To manually search for coins with big funding fees and calculate APR at the same time is not very convenient. What if the funding rate changes quickly? What are the risks associated with it? All these questions are solved by DeCommas – the platform offers you the best automated delta-neutral strategies based on the principle described above. This is where you can see your profit and view the details of the strategy as well as its risks.
Again, let’s go over the main concepts of basis trading:
- A trader makes money on the price difference between a derivative and an underlying asset;
- Basis trading is very common in many industries where there is a factor of uncertainty towards the end of the production cycle. In crypto, basis trading is also gaining popularity, but unlike other industries, crypto traders use mostly perpetual futures;
- The main profit source from basis trading with crypto is funding;
- Funding relates to a special feature, designed to keep perpetual futures prices as close to spot prices as possible. Funding fees are paid every few hours.
Base trading is one of the ways to profit, even when the market shows no signs of noticeable volatility. The strategy has been used with traditional commodities for a very long time, but it will also be useful for crypto traders. Thanks to DeCommas, basis trading can be automated and even a novice investor can profit from it.