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Eqonomics

Playing The Curve: Part II Yield Strategies

March 4, 2022

Adam Wise

Playing The Curve: Part II Yield Strategies

In the last Eqonomics, we looked at futures curve dynamics, concluding with a simple BTC replication trade. This time we move to the second part of the series, focusing on market neutral yield strategies.

Dated futures recap

As a reminder, the difference between dated futures curves:

  • Contango – the curve is in contango when futures prices are above spot price.
  • Backwardation – the curve is in backwardation when futures prices are below spot price.

Investors can replicate their spot position and earn a yield when the curve is backward, thanks to a discounted dated futures price. See last week’s article for details of this idea.

 An alternative ‘long only’ strategy is to replicate a spot with a perpetual futures position. You can read about that here.

Can we capture yield in backwardation without taking price risk?

We can, but this trade should be treated as opportunistic and with caution.

We need to long BTC dated futures but also short another BTC instrument, and this will mitigate directional exposure and isolate that yield. Ideally, we would borrow BTC, but this isn’t straightforward. However, we can short BTC perpetual futures (“perps”).

BTC perps are designed to mimic spot. They do not have an expiry but require that one side of the trade pays the other a ‘basis.’ If perps are trading below spot, then shorts pay longs (and vice-versa). The basis payment is the spread between spot and the perpetual futures, and it is paid every 8 hours.

A full explanation of perps can be found here. Historical payments can be found here.

Example trade:

- Buy 1 BTC March Futures BTC/USD[220325]

- Sell 1 BTC Perpetual Futures BTC/USD[F]

Instrument

Price

Description

BTC/USD [220325]

$42,000

March Futures

BTC/USD [F]

$42,500

Perps




Spread

$500

Perps – Mar Futures

Figures used are for indicative purposes.


You will need adequate collateral (USDC, BTC or ETH) in your account to open this trade. The trade would run at just below 9x leverage if 10,000 USDC was deposited.

Basis payments will be added or subtracted from your USDC balance three times a day.

The trade needs to be closed prior to expiry (or hold enough USDC to settle long futures position). The convergence of the spread between perps and dated futures will be captured.

Date

Action

BTC Mar. Fut.

BTC Perps

Basis

USDC

4th March

Deposit USDC

0

0

0

10,000

Buy BTC Mar.

1

0

0

10,000

Sell BTC Perps

1

-1

0

10,000

4th – 24th Mar.

Basis Payments

1

-1

-315

9,685

24th March

Trade Settled

0

0

0

10,185


Yield = $185 / $10,000 = 1.85%


This is a 21-day trade. Divide by 21 and multiple by 365 to estimate annualized yield: ~32%

Due to market structure, the perps basis will often be unfavorable when futures are backwardated: shorts pay longs. You need to earn more the converging spread than you potentially pay in basis payments. Basis payments are independent and vary every 8 hours, hence a very opportunistic trade.

This trade is attractive when:

  • Futures are in backwardation, but close to expiry : Convergence of the futures to perps near expiry. Shorter-term ‘basis risk’.
  • Futures are heavily backwardated: Opportunity to benefit from spread tightening. Usually across a short time horizon.

Notes & Assumptions:

  • You may be required to post more collateral if BTC price moved +/- $10,000.
  • Total basis payments can only be known retrospectively.
  • Over a 21-day trade, there would be 63 basis payments.
  • Average basis payment of -$5 per 8-hour period, totaling -$315.
  • The full $500 spread, between dated futures and perps initial prices, is captured

What if the curve is in contango?

This presents a simpler opportunity to earn yield, removing the variability of basis payments. It is a popular trade as you lock in your yield at entry.

Example trade:

- Buy 1 BTC Spot BTC/USD

- Sell 1 BTC June Futures BTC/USD[220624]

Instrument

Price

Description

BTC/USD

$42,500

Spot

BTC/USD [220624]

$44,000

June Futures




Spread

$1,500

Jun Futures – Spot

Figures used are for indicative purposes.

The spot BTC will act as collateral for the dated future, and there is no need to have additional USDC in the account. I have used 1 BTC as the example, but it can be as little as 0.0001 BTC for each leg (yes, less than $5!).

Date

Action

BTC

BTC Jun. Fut.

USDC

4th March

Deposit USDC

0

0

42,500

Buy BTC

1

0

0

Sell BTC Jun. Fut.

1

-1

0

24th June

Trade Settled

0

0

44,000

At the expiry of the futures contract, the trade will ‘collapse’ into itself, automatically selling the 1 BTC spot position to settle the short 1 BTC futures position.

You will receive the favorable spread between spot and dated futures in USDC. This spread is calculated when entering the trade.


Yield = $1,500 / $42,500 = 3.53 %


This is a 113-day trade. Divide by 113 and multiple by 365 to estimate annualized yield: ~11%

Whilst this trade’s yield will be realized at expiry, investors could face a mark-to-market drawdown before expiry. This will occur if the BTC futures price diverges from spot. This doesn’t affect the result; it means you can now enter at a wider spread. In this situation, most investors would simply add to both legs of their position for additional returns.

Lastly, due to holding a spot position, you will be unable to apply leverage.

This trade is attractive when:

Futures are in contango – the higher the futures price above spot, the more yield on offer.

Conclusion

Both trades can offer attractive returns during different market structures. Capturing yield in contango is the safer play—market neutral trading in backwardation is for the active trader!

Please reach out if you have questions or anything doesn’t make sense.


[email protected]


Next week we move on to trading different dated futures against one another.

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