Okay, low risk and Bitcoin don’t go together at all. If you look at the price trend of the cryptocurrency, it is shaped by high volatility and the large jumps that come with it. But what if there is a trading strategy that allows you to make an investment in Bitcoin and know in advance how much profit you will make? The basis for this opportunity is called contango. Learn how you can take advantage of this situation with Bitcoin and other cryptocurrencies on the Binance trading platform.
As with all arbitrage trading opportunities, taking advantage of contango is about leveraging the price difference of two related markets. In this case, it is about the price difference of the spot and futures price of an asset. If you don’t know exactly how trading with futures contracts works, I highly recommend reading my article about it.
Futures contracts for dummies – a simple explanation
Contango: The correlation of spot and futures market
Investors can trade assets and futures of assets completely separately from one another. However, the prices are linked to each other in the sense that the spot price of an asset forms the basis for the price of its futures.
For example, if the Bitcoin price is $60,000, investors certainly do not expect a price of $10,000 in three months. Consequently, investors form their expectations based on the current market value of BTC. A price of $62,000 or $58,000 in the future would be more realistic.
As already described in my article about trading futures contracts, the spot and futures rates continue to converge until the delivery date. On delivery, the two prices are inevitably the same.
What is contango and how to benefit from it?
The opportunity for your profit is based on the following facts:
- In a bull market, the futures price is higher than the spot price.
- On the delivery date, futures have the same value as the underlying asset.
This price situation is called contango and it can be leveraged by applying the Cash And Carry arbitrage trading strategy. Investors profit from it by shorting futures contracts (Short Selling? Long Buying? Finally a Simple Explanation). In addition to short selling futures, they simultaneously buy the underlying asset. The investor thus buys an asset in the cash market («cash») and carries it until the delivery date of the shorted futures contract («carry»). If the price of the asset falls, its futures price also falls. Consequently, the investor makes a loss on his purchased asset, but a profit on his futures investment. In turn, if the price of the asset rises, its futures price also rises. Thus, the investor makes a profit on the purchased asset and a loss on its futures investment: the investment is in a neutral position.
You buy an asset and at the same time you sell a borrowed one at a higher price.
Contango with commodities
In my post about futures trading, I wrote about John and the coffee vendor. John decides to enter into a futures contract to prevent having to store the coffee beans until delivery. In exchange, he is willing to pay a little more per kilogram of coffee.
If John wants to take advantage of the contango price situation, he has to accept storage costs. On the one hand, he buys coffee beans and, at the same time, he sells a futures contract to Robert, his colleague, who also owns a store. Since John has to pay for the storage costs, his profit is also lower, which is therefore calculated at the time the goods are handed over to Robert as:
When trading stocks and cryptocurrencies, there are no storage costs. In return, trading fees have to be taken into account, which are many times lower.
A simple example of arbitrage trading with contango
Warren read an exciting blog post about the contango price situation. Now he wants to profit from the price difference of the Bitcoin spot and futures market. The two markets have the following parameters on 10/15/2021:
- Spot market: $60,000
- Futures: $62,000
- Futures delivery date: 12/31/2021
Warren buys 1 BTC and goes short with 1 BTC futures. As collateral, he deposits the bitcoin bought on the spot market. The bitcoin is worth less than the shorted futures contract. But since the futures market only requires a collateral of at least 50%, the purchased Bitcoin is completely sufficient.
Over the following months until the end of the year, the price runs according to the diagram above. That is, the two prices start with a difference of $2,000 and both values meet on December 31 at $60,300. Warren set up an Excel spreadsheet in which he tracked his profit.
The Excel table shows that the profit and loss of the two markets always balance each other out. In addition, the convergence of the two prices shows up as a profit for Warren. Whereas on 10/15 there was a difference of $2,000, on 11/30 the difference is only $800.
On December 31, the futures contract expires and Warren has to deliver. Accordingly, he «hands over» his Bitcoin bought on the spot market and collects the $2,000. Warren has thus realized a return of 3.33% within 3 months. Projected over the year, this results in an interest rate of 13.33%.
Unlike the stock markets, cryptocurrencies do not require to trade entire units. Therefore, Warren could have traded only a fraction of a Bitcoin. With a trading volume of 0.5 BTC, this would result in a profit of $1,000, which of course would still correspond to a return of 3.33%.
In addition, Warren has the opportunity to liquidate the investment at an early stage and take the profit. However, if he does not need the money and does not see a better opportunity, it is pointless to abandon the investment due to the low risk associated with taking advantage of the contango price situation.
Risks and side effects
Yes, the headline of the article is catchy and makes you sit up and take notice. I write about low risk and profit which is indeed the case when used correctly. In principle, there is no market price risk. The investor is only exposed to a price fluctuation between the time of the purchase in the spot market and shorting in the futures market. In the following chapter, my example shows that I was exposed to exactly such a fluctuation (because I dawdled!). Fortunately, the fluctuation worked out in my favor.
Hands-on: Leverage contango on Binance
Of course, I have already leveraged the correlation of the futures and spot market price. The following guide should help you to find your way around as well. Since I spend a lot of time on Binance for advanced trading, the screenshots were taken there.
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1. Compare both markets
To check the potential return, I usually compare the current price value of the spot and futures market.
- Binance BTC futures quarterly: binance.com/en/delivery/btcusd_quarter
- Binance BTC spot market: binance.com/en/trade/BTC_USDT
The screenshot on the left shows that BTC futures are trading at a price of $65,534.8. The one on the right shows the spot market of Bitcoin. Its price at the time the screenshot was taken was 63’366.65 USDT. Neglecting the trading fees, this results in a potential return of 3.42%.
2. Purchase of bitcoin and transfer it to the futures wallet
In the spot market you buy Bitcoin for the value you want to invest. The following screenshot shows a purchase for 100 USDT at the current market value.
In order to be able to trade with futures and benefit from the contango price situation, you have to deposit a collateral as described above. The BTC bought with the 100 USDT should form this collateral. For this reason, you now switch to Binance Futures -> Coin-M Delivery. There you click on the button «Transfer», which opens a popup window.
After buying BTC in the spot market, it is recommended to transfer to the futures market and open a short position quickly. The market moves in the meantime and the purchased BTC are exposed to its fluctuations without protection. A neutral position is reached only after you have placed the order in the futures market.
Select the amount of BTC you have previously purchased in the spot market and click «Confirm».
3. Adjust leverage and short futures
Binance offers to trade futures with 125 times leverage 🤯. Do yourself a favor and don’t do that. In this example we don’t want to use any leverage at all in order to trade with minimal risk. Therefore, click on the button above the purchase form (framed in golden in the screenshot) to adjust the leverage. In the popup window that opens, reduce it to 1x.
Now you are ready to short BTC futures. To do so, select «100%» in the form which overlays the graph and click «Sell/Short».
Congratulations, your investment is in the contango price situation. Now it’s time to wait and collect your profit.
4. Monitor futures wallet
After you have placed your short sale, go to your Futures Wallet -> Coin-M Futures. There you will see the total value of your assets: your collateral + your shorted futures.
It is important that you always look at the total value (framed in golden in the screenshot). In my example the value of «Total Unrealized PNL» is positive. However, it can very well be that this slips extremely into the negative. For example, this is the case when the price of Bitcoin increases enormously and thus depresses the value of your futures short position. But this is not tragic, because you still have Bitcoin in your wallet, which profit from the price increase.
I took the screenshot right after shorting BTC futures. You can see that the value is higher than the 100 USDT invested before. This is probably due to the fact that the BTC price has increased between buying on the spot market and short selling on the futures market.
About ten days after my investment, my futures wallet shows the following parameters.
The image shows that my futures investment has earned me a profit of $5.41. At the same time, the BTC deposited as collateral has a value of only $96.97. Compared to the previous screenshot, you can see that taking advantage of the contango price situation generated a profit of about $1 so far. In fact, the total value is now $101.98 compared to $100.99 ten days earlier. By the delivery date, the investment should generate a return of about $3 according to the pre-calculation. At the end of the year, I will update my findings in this post. Stay curious!
Cash and carry arbitrage is not the only arbitrage trading strategy. Especially with cryptocurrency it is worthwhile to look into perpetual futures spot arbitrage where it is all about the so-called funding rate: Funding Rate: Is This Free Money?
Update 01/05/22
5 days ago my position expired and I intentionally did nothing. On December 30, I received an email from Binance informing me of the expiring contract.
Even after the email, I did nothing. And there you go, Binance liquidated the position at 09:01 am on the settlement date (12/31) and credited me the earnings.
The screenshot from the order book shows a positive BTC profit. It should be noted that this may well be negative. In this case, the Bitcoin price would have risen in the meantime. The profit thus would have been made through the rising Bitcoin price instead of through the short position.
It is important to sell BTC quickly after liquidation, as the asset is no longer in the neutral contango position.
