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Posted on Aug 10, 2022Read on Mirror.xyz

What is Basis Trading?

Basis trading is an arbitrage strategy where you go long on an asset in the spot markets and go short using perpetual swaps. Also known as the “cash and carry” strategy, this technique is popular in traditional financial markets and can be applied to the cryptocurrency markets. 

A typical arbitrage strategy involves buying an asset on one exchange with a lower price and selling it another for a higher price, known as cross-exchange/spatial arbitrage. Basis trading is another delta-neutral strategy that insulates the investors from price fluctuations, but the difference is that this strategy utilizes derivatives (futures or perpetuals).  

Delta-neutral: delta (Δ) is a term used to describe the estimated change in price of a derivative given a $1 change in the underlying asset. For example, the delta is negative for a short perpetual position, since if the underlying asset increases in price, the value of the position decreases. Delta-neutral refers to a situation where the overall position of delta is zero, i.e., no price exposure, by combining two positions with positive and negative deltas that cancel each other out. 

For basis trading using perpetual contracts, the strategy takes advantage of the funding rate. As a periodic payment paid by traders, the funding rate is a mechanism to bring the price of a perpetual futures contract in line with the price of the underlying asset. If you’re not familiar with what funding rates are, read our explainer below:

https://perpprotocol.mirror.xyz/0IHC2DWNKYi9iOwxT21LGPx8t6cny3HZRIPYN_lpjG4

When the funding rate is positive, that means traders who are short using the perpetual futures contract will receive payments from traders that are long. In this case, the price of the perpetual swap contract for ETH will be higher than the current market price. What the funding payments do is to incentivize traders to take on short positions and bring the price of the perpetual future in line with the price of the underlying asset. 

Traders can then go short and earn funding payments in this scenario. But if the price of ETH pumps, then the short position is exposed to losses. To hedge against any price fluctuations, the investor can simultaneously buy ETH in spot markets to counteract the profit/loss of the short perpetual position. 

As long as the funding rate remains positive, then you’ll be earning funding payments. If the price of ETH falls, then the profit from the short perpetual position will cancel out the losses from the spot position. On the other hand, if the price of ETH rises, the losses from the short perpetual position will be approximately equal to the gains from holding spot. 

No matter what the price does, whether it goes up or down, the basis trade ensures that you make money, providing funding rates remain positive. The profit from this strategy derives from the ‘basis’, that is the difference between the price of an asset in spot markets and the price of a perpetual futures contract. As well as being delta-neutral, basis trading strategies can be very lucrative, especially in bullish market conditions, offering traders a steady return without any directional risk. 

Let’s make the concept of basis trading clearer with an example.

Implementing a Basis Trading Strategy

To create a basis trading strategy, a trader can buy 1 ETH through spot markets, i.e., such as Uniswap, using USDC or another stablecoin. At the same time, USDC can be used as collateral to go short on ETH-USD with a position size of 1 ETH using Perp v2

Since you have long exposure after buying ETH on Uniswap and the exact same exposure but to the short side using perpetual futures contracts, the profit/loss of each trade will cancel the other out. However, since you’re short and the funding rate is positive, you’ll be earning funding payments, which is paid by the traders who are long the perpetual futures contract on Perp v2

If the funding rate for ETH remains positive, the basis trading strategy should be profitable and any trader who is short continues to receive funding payments. However, when the funding rate turns negative, any trader that holds a short position will start paying (instead of receiving) funding payments and the basis trade should be closed out by selling the ETH spot holdings and closing the short perpetual position. 

The funding payment depends on market conditions and the number of traders that are long or short on Perp v2. For example, if the market is bullish and most traders take on a long position, then the funding rate will be positive. On the other hand, if the market is bearish and most traders are in a short position, then the funding rate will turn negative.

Automating a Basis Trading Strategy

There are several ways to automate such strategies by using third-party providers that build on top of Perpetual Protocol, making it more convenient to execute a basis trade. Here are some examples of the vaults built on top of Perp v2 that automate a cash and carry strategy:

  • GalleonDAO’s Basis Yield ETH Index ($BYE): This is a tokenized basis trading strategy built using Set Protocol for ETH-USD. By entering a short position for ETH-USD on Perp v2 combined with a long spot position in ETH using Uniswap, holders of the $BYE token can earn funding payments. 
  • Diamond Protocol’s Cash and Carry ETH vault: users can deposit USDC into this vault, which is split between going long on ETH via spot markets and shorting ETH on Perp v2. An algorithm is used to find the best rebalance frequency for the current market and rebalance automatically for the vault’s depositors. 
  • DeComma’s PERP-ETH-MAINNET vault: this basis trading vault works similarly to Diamond Protocol’s vault, where a short position is taken on Perp v2 and a long spot trade is taken on Uniswap v3. 
  • IndexCoop’s Market Neutral Yield ETH ($MNYe): Made possible with Set’s integration with Perpetual Protocol on Optimism, $MNYe contains a fully hedged ETH position, with equivalent spot exposure and short exposure via perps. Token holders will earn a variable USDC return when the funding rate is positive, while removing all exposure to price volatility of the underlying asset.

Summary

Implementing a basis trading strategy allows traders to earn low-risk yield from the funding payments when they are positive, without having any directional exposure.  

However, the risk is that market conditions change and funding rates switch from positive to negative, meaning that any short positions will cost money in terms of funding payments to keep the position open.

Therefore, the profits generated from such a strategy are highly dependent on the funding rate and whether it stays positive over time. Also, if you’re using a third party provider for a basis trading vault, there’s also smart contract risk, since you are depositing your funds into a smart contract to execute the strategy for you.

But if most market participants are bullish on the future of crypto, then there’ll tend to be more open long positions as compared to shorts. As a result, the basis trade would be a profitable strategy over the long term, offering investors a steady return without having to predict where the market will go next.

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