Key Takeaways

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• Basis trading is an arbitrage strategy that capitalizes on the price difference between spot and futures markets.
• It is market-neutral, meaning traders profit from price discrepancies rather than betting on market direction.
• While generally low-risk, basis trading requires careful execution to manage liquidity, margin requirements, and unexpected market shifts.

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If you've ever traded crypto futures or explored arbitrage strategies, you've likely encountered "basis trading." This strategy is widely used by professional traders to capitalize on differences between spot and futures prices. But how does it work, and why is it so popular? Let's break it down in simple terms.

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‍Understanding Basis Trading

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Basis trading is an arbitrage strategy that takes advantage of the difference (or "basis") between the spot price of an asset and its futures price. In an efficient market, futures contracts should closely track spot prices. However, in crypto markets—where volatility and market inefficiencies are common—discrepancies can arise. Traders exploit these price differences to generate returns.

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A common trading strategy amongst institutional or HNW individuals in crypto is to hold a spot long position in one currency and then short an equal and opposite amount on the perpetual future contract. The aim here is to profit from the funding rate on the perpetual future contract while having no directional pricing risk because any gain on the spot long will be offset by a loss on the perpetual short, and vice versa. Spot and Perp markets usually operate in tandem and are not exposed to movements of the markets, making basis trade positions delta neutral.

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Backpack levels up the Basis Trade with yield from multiple sources. Instead of only earning the Funding rate of the Perpetual Futures short positions, you also earn yield on lent collateral. This example uses SOL as the asset, but on Backpack the basis trade can be applied to any market with a perpetual future.

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On the chart below you can see that on the majority of days there is a positive funding rate on the Perpetual Future contract. This means that longs ‘pay’ funding and shorts are ‘credited’ funding. On the days when funding is negative, the opposite is true. As 90%+ of days have positive funding, over a long time horizon the funding trade achieves relatively low but near risk-free yield.

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Key Terms to Know

• Spot Price: The current market price of an asset.
• Futures Price: The price agreed upon today for an asset to be delivered in the future.
• Basis: The difference between the futures price and the spot price.
• Contango: When the futures price is higher than the spot price.
• Backwardation: When the futures price is lower than the spot price.

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How Basis Trading Works

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‍Basis trading involves two main strategies:

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Cash-and-Carry Arbitrage (Contango Scenario)

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1. Traders buy the spot asset (e.g., Bitcoin) and sell a futures contract at a higher price.
2. Upon contract expiration, they deliver the asset at the futures price, locking in the profit from the basis.
3. This strategy is considered market neutral, meaning the trader isn't exposed to directional price risk.

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Reverse Cash-and-Carry Arbitrage (Backwardation Scenario)

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1. Traders short the spot asset and buy a futures contract at a lower price.
2. When the contract expires, they buy the asset at a lower futures price and return the borrowed crypto, capturing the price difference.
3. Again, this is a market-neutral strategy that profits from price discrepancies rather than price direction.

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Basis trading example

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Basis traders look for price differences between the spot market (where assets are traded instantly) and futures contracts (which track the cryptocurrency’s future prices).

For example, if SOL is trading at $200 in the spot market, but SOL futures are priced at $250, Alice could buy SOL on the spot market while selling the same amount of SOL in the futures market.

• Spot price: $200 per SOL.
• Futures price: $250 per SOL.
• Basis: $50.
• Rationale: Alice believes this $50 gap (basis) will shrink over the next few weeks due to increasing spot demand or decreasing futures premium.
• Strategy: Alice executes a cash-and-carry arbitrage, buying SOL in the spot market for $200 and selling a BTC futures contract for $250.
• Outcome: If the prices converge as expected, Alice uses the SOL bought in the spot market to fulfill the futures contract, effectively locking a $50 profit per SOL minus fees and operational costs.

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Why are Basis Trades more efficient on Backpack?

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‍Interest on Lent Assets: ‍‍There is a unique feature on Backpack that enables lent assets to continue to be used as collateral for other margin or futures activity.

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As such, the Spot Long positions can be put into the lending pool and the holder earns this yield. This is an additional element of PnL that does not exist on other centralized exchanges and is possible due to the unique ‘cross-margin per subaccount’ setup of Backpack’s margin system.

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Why Do These Price Differences Exist?

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Futures prices are influenced by a variety of market factors, including expectations of future price movements, funding rates, and overall liquidity. Several elements contribute to discrepancies between spot and futures prices. Supply and demand imbalances can lead to contango when futures prices exceed spot levels, or to backwardation when futures prices fall below spot levels. Market sentiment also plays a crucial role—bullish trends often push futures prices higher, while bearish outlooks may result in lower futures valuations. Additionally, interest rates and carrying costs, such as borrowing fees, affect the cost of holding assets and contribute to pricing differences.

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Risks of Basis Trading

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Despite its reputation as a relatively low-risk strategy, basis trading comes with potential challenges. Liquidity risks can arise when markets are thinly traded, making it difficult to execute both legs of the trade effectively. Margin requirements must also be considered, as futures trading often necessitates maintaining capital reserves. Moreover, unexpected market shifts—caused by sudden regulatory changes or shifts in investor sentiment—can disrupt price relationships and impact the profitability of trades.

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Why Traders Use Basis Trading

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Basis trading remains a preferred strategy for many traders due to its structured approach to profit generation. One of its key advantages is its market-neutral nature, which allows traders to capitalize on price differences rather than speculate on market direction. Additionally, when executed correctly, basis trading reduces exposure to market volatility, making it an attractive option for those seeking lower-risk arbitrage opportunities. Many institutional traders and funds employ this strategy to secure consistent profits in an otherwise unpredictable market environment.

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Final Thoughts

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‍Basis trading is a powerful tool for traders looking to profit from inefficiencies in the crypto market. While it requires an understanding of futures markets and margin trading, it provides a structured way to generate returns without taking on significant directional risk. As crypto markets continue to evolve, basis trading remains a core strategy for both retail and institutional traders.

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