This text is focused to the intermediate and complex merchants who’re already conversant in the fundamentals of index arbitrage. There are different assets obtainable on OKEx Academy for those who want extra explanations on the ideas of foundation, margining and truthful worth calculation. In the present day, we’re going to debate a commerce that may have returned >10% final month. The concept is similar to the borrow and carry commerce mentioned right here. For ease of dialogue, we assume that we construct an index arbitrage place on February 12 after which unwind it on March 13 on the most favorable time. Nonetheless, the meat of the dialogue arises from the dialogue of how you can maximize return on capital and decrease danger through the use of each OKEx’s inverse and linear futures.
The Vanilla Buying and selling Concept
The graphs beneath present the share foundation on Feb 12 and Mar 13, 2020. Every graph consists of the % foundation of each OKEx inverse coin-margined USD futures and linear USDT-margined futures. On a fast look, we are able to see how linear future foundation is constantly larger than the inverse future foundation, which we are going to focus on later. This unfold between the 2 BTC quarterly futures is pushed by the exterior lending fee of the underlying and in addition how margining works.
On Feb 12, the market was buying and selling contango, close to quarter futures had been buying and selling ~5% above spot worth, and the buying and selling ground lingo we should always use is that the futures had been buying and selling ‘wealthy’. One month afterward March 13, the market traded at backwardation, with close to quarter futures buying and selling at trough of~-15%, each futures had been buying and selling ‘low-cost’. The commerce is to purchase spot & promote wealthy futures on Feb 12 after which unwind by promoting spot & shopping for again low-cost futures on Mar 13 for a hefty 20% return for a one-month holding interval. The concept of this index arbitrage commerce is sort of easy however the satan is within the particulars.
Maximizing capital utilization and maximizing revenue
Timing the idea is unattainable so that you don’t count on to really make this 20%. Since we’re not in a position to predict futures foundation and don’t know when is the precise time to construct and unwind our stock, let’s check out different components of the equation, which futures to make use of and why. We’ll now flip our consideration to maximizing our return per capital and reducing our dangers.
Nuance 1: If inverse and linear futures have the identical constructive foundation, it’s higher to make use of inverse futures to construct index arbitrage place?
OKEx is the one change that gives each inverse and linear futures. The margin of those BTC futures is BTC and USDT respectively. Now, assume you will have $10,000 for arbitrage, which implies you should purchase $10,000 value of BTC and promote $10,000 value of BTC futures. Which future must you use? The USDT future really has the next foundation of ~0.7 on account of their margin necessities. In the event you select inverse futures, you’ll purchase $10,000 of BTC and use it as the longer term collateral, basically you’ll by no means get forced-liquidated due to the inverse payout nature (see example1).
# Instance 1: (Assume price = 0, leverage = 10x)
Entered at 15:00:00 on Feb 13, the liquidation worth is infinite.
Assume we maintain the place till expiry and unwind the spot place and settle the longer term on the identical worth (and 1 USDT = $1) , your return will be ~5%, which will be round 0.0492 BTC （~$513）.
In the event you determined to seize extra foundation with the linear USDT futures, you have to reserve a big amount of money and purchase USDT to margin the linear future. Per index arbitrage place, the idea captured can be extra however per capital utilization, you captured much less greenback foundation. Most significantly, there’s a probability you might get forced-liquidated if the market shoots up, as a result of there are limitless draw back shorting futures.
Nuance 2: If inverse and linear futures have the identical unfavorable foundation, it’s higher to make use of linear futures to unwind index arbitrage place?
Conversely, if each inverse and linear futures are buying and selling at a reduction to identify, which futures must you use and why? Following the above logic, all issues else equal, it’s best to use the linear future to construct a reverse arbitrage place (promote spot purchase future). If you promote spot within the OKEx spot market, you get again USDT. Utilizing this USDT, you are able to do 1:1 margin of your lengthy future place. You’ll basically by no means be forced-liquidated until market drops 1-MMR % (see example2).
Instance 2: (Assume price = 0, leverage = 10x)
Entered at 08:00:00 on MAR 13, liquidation worth can be round ~20.
If unwind throughout expiry on Mar 27, and assuming the linear future settles at $4794, your return shall be 8.4%, which shall be round 840 USDT.
Nuance 3: To maximise capital utilization and use leverage, you are able to do a mixture of promote inverse futures, purchase linear futures.
Assuming 1 USDT = $1, nuances 1 and a couple of explains why linear futures ought to constantly worth larger than inverse futures. If you’re capital strapped, you may strive buying and selling the unfold of the futures. For instance, if there’s a decrease demand for linear futures out there than inverse futures, then the idea of the inverse future shall be larger. You may then purchase USDT futures and promote inverse futures and seize the unfold. Since there isn’t a want to purchase nor promote spot, you may leverage upon this foundation commerce (however watch out of market strikes, it might knock out one leg) and probably earn extra. OKEx’s distinctive USDT linear futures provides rise to extra arbitraging alternatives.
Arbitrage: It’s by no means actually risk-free
In tutorial sense, ‘arbitrage’ means risk-free profiting alternative. This phrase is loosely utilized by merchants, we wish to consider our trades are risk-free, however actually it’s not. The higher merchants had been in a position to survive the darkish March 13th drop as a result of they had been ready for top volatility. Leverage is a double-edged sword, a spot up or down might rapidly liquidate your place earlier than you will have an opportunity to re-margin. The most important index arbitrage dangers we now have are liquidation, clawback, counterparty and tether publicity.
Binance utilized auto deleveraging (ADL), a kind of pressure liquidation on a successful place, on their customers positions on March 12. ADL is far worse for a dealer than liquidation in some senses. To start with, you by no means know when ADL occurs to you. Your draw back of getting your brief place forced-liquidated by way of ADL means, you lose considerably if the market continues to go down. ADL in a future market makes it unattainable to hedge. At OKEx, we don’t use ADL for our Bitcoin derivatives.
As OKEx is a decentralized futures change, we implement a clawback coverage as a substitute, the place successful positions will get deducted a few of their P&L if counterparty positions can’t be forced-liquidated in time and there may be not sufficient insurance coverage funds to cowl the downfall. It is a higher different than ADL, as you’ll solely lose a few of your P&L within the worst-case state of affairs whereas retaining your hedge. Since revamping our danger engine in 2018, we now have not had any BTC clawbacks in any of our BTC derivatives. The Mar 12 drop has proved our refined danger engine to be industry-leading.
As merchants, we are able to attempt to decrease our forced-liquidation danger as we’re conscious of when that may occur. Nuances 1 and a couple of confirmed liquidation dangers will be decreased through the use of completely different futures for taking a protracted or brief publicity. Within the worst case, in case your lengthy hedge place had been forced-liquidated due to margin necessities, there may be nonetheless a excessive probability you may reopen the identical place at a acquire as a result of market continued to drop.
Lastly, while you placed on a place involving Tether (USDT), you’re inadvertently giving your self a counterparty danger in opposition to Tether. For instance, for those who promote wealthy USDT linear futures and purchase low-cost BTC inverse futures, you’re longing USDT and shorting greenback. If USDT de-pegs and crashes with all else equal, BTC-USDT will shoot up and you’ll owe USDT. Conversely, you may take into account hedging any auxiliary tether exposures by buying and selling a mixture of OKEx’s linear and inverse futures.
OKEx’s distinctive mixture of various tenures and varieties of margined futures permits merchants to create many varieties of carry trades. You may arbitrage between completely different implied charges or arbitrage between completely different margined futures. By way of enhancing your danger profile, we confirmed that there’s much less margin name danger shorting inverse futures than shorting linear futures (and vice versa). Lastly, you may construct a place between linear and inverse futures to hedge tether publicity. Taking all varieties of tenures and merchandise in consideration, OKEx have the deepest liquidity and finest buying and selling alternatives of all exchanges.
Disclaimer: This materials shouldn’t be taken as the idea for making funding choices, nor be construed as a suggestion to have interaction in funding transactions. Buying and selling digital belongings entails important danger and can lead to the lack of your invested capital. It’s best to make sure that you absolutely perceive the danger concerned and consider your stage of expertise, funding aims and search impartial monetary recommendation if needed.
In regards to the Creator: The writer of this text is Thomas Tse, Head Quantitative Strategist at OKEx.