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Eqonomics

Eqonomics: How to Generate Yield with Perps

January 28, 2022

Adam Wise

Eqonomics: How to Generate Yield with Perps

Welcome to Eqonomics, the new weekly crypto trading newsletter from EQONEX. This week, we look at how you can use a perp trading strategy to generate yield.

WHAT IS A PERPETUAL FUTURES CONTRACT?

The most obvious and distinctive feature of a perpetual futures contract ("perp") is there is no expiry, meaning:

  • no rolling of contracts 
  • no pre-determined convergence with spot

A perp is designed to offer simple access to leverage. It aims to mimic a spot position.

Read a complete guide on trading perpetual futures here.

HOW DOES THE PERP REMAIN IN LINE WITH SPOT?

When the perp is trading at a premium to spot, anyone holding the long side of the trade pays the short side a basis payment (chart 1, below).

The basis payment is derived from spot price less perp price, using prices observed across a defined period.

When the perp is trading at a discount to spot, anyone holding the short side of the trade pays the long side a basis payment (chart 2, above).

Should demand for short positions increase, the perp will continue diverging below spot and drive the basis more positive.

basis = spot - perp

The knock-on effect of this helps regulate that divergence:

  • Holding a short position eventually becomes very expensive…
  • …Which creates opportunity and demand to take the long side and get paid (what we want for this trade).

HOW DO I MAKE A PERP TRADE?

Simply sell down your ETH spot position to USDC and then open a long perp position for the equivalent units of ETH.

Leverage will initially be ~1x since you are converting your spot position to USDC and long ETH perp.

This only works when the ETH perp is trading below the spot, meaning you will be paid to hold a long position.

WHAT WILL I BE PAID?

Basis payments are settled every 8 hours, in USDC and straight into the same Sub Account. The amount is paid in USDC per 1 ETH perp that is open.

In this example, $0.82 would be paid to longs by shorts.

This number varies, and the payment depends on whatever the basis is at the time of funding payment. (Note: in this example, there is 1h 49m until the next payment.)

See historical payments here.

Select ETH/USDC[F] from the dropdown.

Over the last six months*, shorts would have paid longs around 1/3 of the time.

Over the last three months*, shorts would have paid longs around 1/2 of the time. 

 *as of 22 January 2022

HOW DO I CALCULATE MY YIELD?

If we roughly take the numbers above and use $2,360 as the ETH perp price and $0.8 as the basis, you get:

$0.8 x 3 x 365 = $876 as our annualized $ yield.

We multiply by three as basis payments are every eight hours, i.e., three times a day.

$876 / $2360 = 37% yield

This is a ‘snapshot’ yield, and payments will vary every eight hours.

IS IT TOO GOOD TO BE TRUE?

As with all trades, there are risks involved.

The omnipresent risk is that the basis flips direction: in this case, longs pay shorts, rendering the trade loss-making. Under these circumstances, positions can be closed out quickly, though there remains the burden of transaction costs from entering and exiting. This becomes a pure cost if the basis flips before any payment has been received.

Additionally, while the trade is structured to match a long ETH position, investors are exposed to any unfavorable divergence between the respective spot and perp prices when closing (and rebuying ETH spot).

That being said, you would close out this trade if spot < perp (negative basis), so it’s working the right way around when closing perp position to buy spot.

You don’t carry any liquidation risk, as the trade is fully funded from the USDC position.

FINAL THOUGHT: CAN I BOOST THE YIELD FURTHER?

If you are comfortable managing liquidation risk, there is no need to keep the full amount of USDC as collateral.

For example, you could use half the USDC collateral elsewhere and run the position at 2x leverage. After that, it would be up to you to determine how much risk you take on the capital you have freed up.

Treat this approach like selling tail risk.

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