Have you ever wondered what a basis trade is? Here, we introduce the concept of a spot-futures basis, including what a basis is, why it exists, and how to trade it.

What's a basis?

Many cryptoassets have futures markets. For instance, ETH has a fixed date futures contract on FTX that expires on December 30. The markets for the asset itself are called spot markets, and the markets for the futures are called futures markets. Since spot and futures are traded separately, their prices are not guaranteed to be the same at all times. In fact, their prices often diverge. For instance, at the time of writing, the price for the ETH/USD spot is $1719.80, whereas the price for the December 30 expiry futures, ETH-1230, has a price of $1723.50. We define the basis \(b\) as being the difference between these spot price \(p_s\) and the futures price \(p_f\)^[1].

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\[b = p_f - p_s\]

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In the aforementioned ETH case, the basis would have a value of $1723.50 - $1719.80 = $3.70. It is easier to compare the basis in percentage terms, in which case we can state the the basis percentage is

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\[b_\% = { p_f - p_s  \over p_s }. \]

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This value changes over time, as can be seen here.

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How can you trade a basis?

At expiration, futures contracts require the person long the contract to purchase the underlying asset at the contract’s predetermined price^[2], guaranteeing that at futures contract expiry \(p_s = p_f\), and thus \(b = 0\). Therefore, as the futures expiration draws nearer, \(b\) should approach 0. And if \(b\)  remains high in magnitude just before the expiration, this provides an opportunity for traders to make risk-free profit (aside from counterparty risk and minuscule basis risk, as discussed below).

A basis trade is a trade in which the trader simultaneously purchases (sells) an asset and sells (buys) the futures contract for that asset^[3]. This definition can be extended to include trades between futures with different expiry dates, however here we only analyze spot-futures basis trades.

The simplest form of a basis trade, which can be performed when the basis is positive, is to simultaneously purchase \(x\) units of the spot asset and sell \(x\) units of the futures contract, then hold these positions until contract expiry. This strategy yields a gross percentage return of \(b_\%\). In our ETH example, this return would be $3.70 / $1719.80, or 0.215%, achieved by holding for about half of a year; this annualizes to 0.510% annual return. This trade is called “going short the basis”.

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If the basis is negative, then spot prices are higher than futures prices, and traders can make the basis by shorting the spot asset and going long the futures contract. However this trade is more complicated, since shorting the spot asset requires taking a margin loan of the spot asset. Margin loans typically have a variable interest rate, and thus unless the loans used to short the asset have fixed interest, this trade does not yield a fixed return. This trade is called “going long the basis”.

Both of the aforementioned examples entailed the trader holding their positions until expiry, however this is not necessary. For liquid crypto assets, traders can speculate on the basis, going long or short, and exit their positions at any time prior to contract expiration.

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Why does the basis exist?

The difference between futures and spot prices originates from differing levels of demand for futures and spot products. So our question becomes: why would one prefer owning spot vs. going long a futures contract on a crypto asset? Here are a few reasons that might make one more attractive than the other.

• For traders who want access to leveraged price exposure, futures are typically the most capital efficient way of achieving this exposure.
• For traders who do not want to take custody of assets, they may prefer using futures rather than spot assets. This has historically made futures accessible to institutional investors through tradfi venues like CME.
• For those who want to use crypto assets for a specific utility, such as to stake on a proof-of-stake blockchain, lend on a money market protocol, or to vote on governance proposals, they must own the spot token itself.

For example, if large institutional investors want positive exposure to a crypto asset, they may go long a sizable number of futures contracts, leading to futures prices to exceed spot prices, creating a positive basis.

Another example is for inflationary tokens that offer yields through interest-yielding pools. Market-neutral traders can harvest yields from interest-bearing pools by shorting futures, purchasing the spot asset, and deposting the spot asset into the pool; this is akin to a short basis trade. This can lead to futures prices dipping below spot prices, thus creating a negative basis.

Roughly speaking, a positive basis occurs when long demand for futures is larger than long demand for spot, and a negative basis occurs when long demand for spot is larger than long demand for futures.

How has basis trading performed historically?

Here we examine some statistics and visualizations regarding the historical profitability of basis trading. The visualizations here should not be interpreted as predictive of future basis spreads, and are instead meant only to illustrate basis behavior in the past.

Case Study: FTX 06/24 Futures

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There are a number of instructive components to these graphs.

Mains vs. Alts. We see that the raw basis percentages for main coins, like ETH and BTC, are smaller in magnitude than those of the other coins.

Futures-Spot Convergence. We see that the raw basis percentages for all coins tend toward 0% as the period nears an end. This should make intuitive sense, considering the fact that there is a large return for a short lock-up period if the basis stays large while the lock-up period is short.

Transaction Costs. We see that the magnitude of the annualized returns percentage for some coins gets quite large near the end of the futures contract term. This can be explained by the fact that our annualized % returns do not include transaction costs, which have an increasingly large effect on annualized return percentage as the futures expiration date nears.

Again, it should be noted that these historical results are not necessarily predictive.

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Where can I trade the basis?

The basis can be traded, at varying degrees of convenience, on any platform that offers fixed-expiry futures products. These include centralized exchanges like FTX and liquiidty networks on top of exchanges like Paradigm. A similar trade, in which traders speculate on perpetual funding rates, can be achieved on a greater variety of venues, including the aforementioned venues, and also decentralized exchanges like dYdX and Perpetual Protocol.

Paradigm enables traders to atomically trade spot vs. perpetual as a single package on FTX. This makes getting into basis trades significantly easier and cheaper than trying to trade each leg separately. In addition, they are free to use and offer 50% off FTX exchange fees. This makes Paradigm a more cost-efficient venue for traders to speculate on the basis.

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Conclusion

The relationship between futures contracts and their underlying assets create the opportunity for an advanced type of trading called basis trading, where traders can speculate on the difference between futures and spot prices. Basis trades with fixed-expiry futures can promise sizeable fixed interest. Paradigm’s product enables traders to place these trades in a seamless manner with reduced fees and zero trade execution headache. Now go forth and trade that basis!

1. Bodie, Kane, Marcus. “Investments”, Twelfth Edition. Footnote on pg. 762. We use their alternative \(p_f - p_s\) definition, since it’s more intuitive to analyze when \(p_f > p_s\).
2. Technically, most crypto futures contracts are cash-settled, meaning shorts do not make delivery to longs.
3. https://en.wikipedia.org/wiki/Basis_trading

Article by

Max Holloway @max_holloway

Xenophon Labs is a Web3 research and development firm that focuses on the intersection of mechanism design and finance to help Web3 companies create sound incentive structures. Max Holloway, the founder of Xenophon Labs and author of this post, previously led a market-neutral crypto hedge fund that employed strategies across centralized and decentralized venues.