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Playing The Curve: Part I Futures Curve Dynamics

February 25, 2022

Adam Wise

Playing The Curve: Part I Futures Curve Dynamics

In this three-part series of articles, we will cover futures curve dynamics, yield strategies, and curve strategies. These will be centered around BTC dated futures contracts, and we start by understanding futures contracts and the ‘curve.’

How do futures contracts work?   

A dated futures contract is an agreement to buy or sell an asset at a specific price in the future. For BTC futures contracts on EQONEX, they are physically delivered. If you have bought (long) a futures contract, you receive BTC on expiry and pay USDC.

For anyone selling (short), this is reversed. You need to deliver the BTC in return for USDC. All settlement is handled automatically on exchange, with no slippage.

Here’s a clip that provides a fuller explanation.

Futures curve structure

The existence of dated futures contracts in any market creates a futures curve, also referred to as a term structure. It is the relationship between the price of an asset now versus the implied price of an asset in the future.

This can be best understood graphically by plotting the price of spot and futures contracts versus their expiry dates.

Contango: Futures contracts trade at an increasing premium to spot.

Backwardation: Futures contracts trade at an increasing discount to spot.


How do curves behave in traditional markets?

Futures are priced as spot + (cost of carry - carry return). For the purposes of the following examples, interest rates are treated as 0%. Interest rates are not considered in the cost of carry.

Cost of carry: Taking oil as an example, the curve is commonly upward sloping – contango. There is a cost to store the oil until contract expiry. A futures contract trading at a premium to spot is pricing this in. The further away the expiry, the larger the embedded storage cost.

Carry return: Whilst contango is considered ‘normal’ in most commodities, for dividend-paying stocks the logic reverses. Anyone agreeing to receive stock in the future would forgo intervening dividends. This opportunity cost pushes futures prices down – backwardation.

These are only indicative examples.

What does Bitcoin's curve look like?

Historically, the BTC curve has more often been in contango. There are neither storage costs nor dividend returns from holding BTC spot. The remaining cost of carry premium (or discount) can be treated as an implied interest rate for funding leverage.

When investors are bullish and want to leverage long, this will drive up the price of futures away from spot. This increases the steepness of the curve. The spread between any future and the spot is the ‘cost’ investors are willing to pay to access leverage.

This is also true when sentiment is bearish. The futures price will fall below spot price as investor demand to go short increases—the case we find ourselves in now.

How do you trade backwardation?

At the time of writing, BTC futures are trading below spot.

Prices as of 24th February 2022. Source: EQONEX.

Instrument

Price

Description

BTC/USD

$35,370

Spot

BTC/USD [220325]

$34,890

March Future

Spread

$480

Spot – March Future


Anyone wanting to earn a yield on their long BTC spot position can sell down spot and enter a dated futures contract for the same units of BTC at a discount in USDC terms.

At contract expiry, you will receive the same amount of BTC units sold today. You are left with a residual USDC amount.

Example using 1 BTC notional.

Date

Action

BTC

BTC Mar. Fut.

USDC

24th February

Deposit BTC

1

0

0

Sell BTC

0

0

35,370

Buy BTC Mar. Fut.

0

1

35,370

25th March

Trade Settled

1

0

480


The resultant yield would be $480, whilst your 1 BTC exposure remains.

Yield = $480 / $35,370 = 1.36%

This is a 1-month trade. Multiple by 12 to estimate annualised yield: ~16%

A similar trade will feature again next week, but in more depth. We will also look at how we can earn a yield when the curve is in contango.

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