One of the golden rules in traditional financial markets is that high risk often leads to high returns. However, as an emerging investment space, the cryptocurrency market is experiencing wildly rapid growth and has challenged the laws of the traditional financial market. In the crypto market, there is a new quantitative trading mechanism that contradicts this golden rule in which high returns are only achieved by taking high risks. Cryptocurrency investors can have an annualised return of 15% to 20% with low risk. This mechanism is spot-futures arbitrage.
Is it a pie in the sky?
It’s not a pie in the sky. In fact, spot-futures arbitrage did not just appear out of thin air. To understand it better, let's take a look at what “arbitrage” and “spot-futures” are respectively. Arbitrage is widely available in all types of financial markets. In academic terms, arbitrage is a spread trade, where someone buys or sells an underlying asset while selling or buying a related futures contract, and then profits from the difference in price. For example, given that there is a cryptocurrency traded at $1,200 on Exchange A and at $1,000 on Exchange B, if an investor buys one unit of the currency on Exchange B for $1,000 and then sells it at $1,200 on Exchange A, $200 will be earned at no cost through this buy and sell transaction.The practice of the investor buying in the market with lower price and selling in the market with higher price, is known as arbitrage.
Arbitrage tends to have more stable returns and lower risk compared to ordinary investments. Traditional financial markets are, in fact, also home to a large number of arbitrageurs, who are constantly taking advantage of the price discrepancies between different markets to arbitrage and thus profit. The arbitrage operation also causes the prices between the different markets to get closer until they are exactly the same and there is no room for arbitrage. Using the same example as mentioned above, assume that a growing number of people discover the price difference between Exchange A and Exchange B, and start to constantly sell the currency on Exchange A and buy it on Exchange B. This leads to a lower price for the currency on Exchange A and a higher price on Exchange B, until the price of the currency on both exchanges is the same and investors can't profit due to price discrepancies.
The term “spot-futures” in “spot-futures arbitrage” refers to perpetual futures and spot. Combined with the above interpretation of arbitrage, spot-futures arbitrage is a trading behavior that utilizes the price difference between ordered futures and spot to arbitrage. As the basis for spot-futures arbitrage, perpetual futures only exist in the cryptocurrency market. So, the term spot-futures arbitrage we are talking about today is actually an arbitrage operation that exists only in the cryptocurrency market. The “low risky, high yield” properties also stem from the perpetual contract in cryptocurrency markets.
So, what is a perpetual contract?
Everything you need to know about a perpetual contract can be found in this article (https://www.gate.com/help/futures/perpetual/16697). A brief summary is that the perpetual contracts are similar to traditional futures, but without an expiration date. Those who are bullish on the price of the currency will make long trades and buy contracts with a high price, while those who are bearish on the price will make short trades and buy low. In traditional contracts, the contract price will gradually get close to the spot price as the delivery date approaches. Perpetual contracts without expiration dates never settle in the traditional sense. To avoid excessive deviations between perpetual contract prices and spot prices, a system of funding rate was devised to link the price of perpetual contracts to the spot price.
The principle behind the funding rate mechanism is that when too many participants and funds in perpetual contracts are operating on one side, a certain funding rate needs to be paid to the counterparty in order to stimulate an increase in the number of counterparty participants and the amount of investments. To be specific:
1. When the market is dominated by traders who are trading long, they need to pay proportional funding fees to traders who are trading short.
2. When the market is dominated by traders who are trading short, they need to pay proportionate funding fees to traders who trade long.
3. When the market is balanced between the long and short sides, the long or short positions don’t have to pay fees to each other.
The percentage of funds paid to the counterparty is the funding rate. The funding fee is the arbitrage profit earned by investors who execute spot-futures arbitrage trading.
Funding Rate Arbitrage
Now that we know what funding rates and funding fees are, how does spot-futures arbitrage help us earn funding fees with low or barely any risk? Before introducing the funding fee arbitrage, a few more points need to be made.
Firstly, the funding rate is settled every 8 hours and will change 3 times a day.
Secondly, the positive and negative funding rates represent the direction of payment, with the positive funding rate showing that traders who are long pay for short positions and the negative one signifying that traders who are short pay for long.
Thirdly, considering that the funding rate for perpetual contracts in the cryptocurrency market is positive most of the time, perpetual contract traders who are long tend to pay fees for short positions in the vast majority of cases.
The following is an example of how spot-futures arbitrage works with BTC spot and perpetual contracts. If the market funding rate is 0.03% and remains unchanged, the arbitrageur will buy spot and short perpetual contracts. Assuming that the current BTC price is 5000 USDT and the investor makes spot-futures arbitrage with an investment of 10,000 USDT with a strategy running time of 365 days:
Firstly, the total funds (10,000 USDT) are divided into two equal parts. Buying 1 BTC (5000 USDT) and shorting 1 BTC in the perpetual contracts markets with 5000 USDT. (without leverage)
Secondly, after shorting the perpetual contract, the investor will get 1.5 USDT.
(1*5000*0.03%=1.5USDT)
Thirdly, during the time the strategy is running, the investor can receive 1095 times of their earnings(365*3=1095; 3 times a day), with a total return of 1642.5 USDT (1095*1.5=1642.5). And the annualized return can reach 16.425%(1642.5/10000*100%).
Users can earn easily using spot-futures arbitrage strategy with the help of Gate Copy Trading, instead of buying spot and contracts themselves.
Low-risk Doesn't Mean No-risk!
Although the spot-futures arbitrage strategy enjoys a low-risk nature, it is not a completely risk-free investment approach. In some extreme situations, it can also result in losses to investors. The main risks are credited to:
1. A change in the direction of the funding rate - When the direction of the funding rate changes during the operation of the spot-futures arbitrage strategy, investors may suffer from losses due to the change from being a recipient of funding fees to a payer. The good news is that the direction of funding rates on Gate is very stable and changes in the direction of funding rates are rare. Occasional losses caused by changes in funding rates can be compensated by the next funding fees.
2. Liquidation - The spot-futures arbitrage strategy requires the use of perpetual contracts to establish a position that involves the use of leverage. When the price of a currency changes significantly, you may get liquidated on your position. In order to reduce this kind of risk, Gate limits the use of leverage in the spot-futures arbitrage strategy. Users can only utilize up to 3x leverage when opening a position.
Use spot-futures arbitrage with one click
Gate Copy Trading has added a strategy — spot-futures arbitrage, which allows users to perform spot-futures arbitrage trading as follows:
1. Go to “Copy Trading” and tap “Strategies Template”.
2. Locate “Spot-Futures Arbitrage”
3. Set parameters
Firstly, you need to select the trading pair for your spot-futures arbitrage strategy.
You can check out this page (https://www.gate.com/cn/futures_info_new/futures/usdt/BTC_USDT#realtimefeehistory) to learn more about the historical funding rate of currencies to be selected and their changes.
Secondly, input the total investment amount. You only need to invest USDT to make the spot-futures arbitrage, without buying the spot.
Lastly, set the leverage. 1x leverage means no leverage is required for the contract, and users can use up to 3x leverage.
Gate reserves the final right to interpret the product.
Is it a pie in the sky?
It’s not a pie in the sky. In fact, spot-futures arbitrage did not just appear out of thin air. To understand it better, let's take a look at what “arbitrage” and “spot-futures” are respectively. Arbitrage is widely available in all types of financial markets. In academic terms, arbitrage is a spread trade, where someone buys or sells an underlying asset while selling or buying a related futures contract, and then profits from the difference in price. For example, given that there is a cryptocurrency traded at $1,200 on Exchange A and at $1,000 on Exchange B, if an investor buys one unit of the currency on Exchange B for $1,000 and then sells it at $1,200 on Exchange A, $200 will be earned at no cost through this buy and sell transaction.The practice of the investor buying in the market with lower price and selling in the market with higher price, is known as arbitrage.
Arbitrage tends to have more stable returns and lower risk compared to ordinary investments. Traditional financial markets are, in fact, also home to a large number of arbitrageurs, who are constantly taking advantage of the price discrepancies between different markets to arbitrage and thus profit. The arbitrage operation also causes the prices between the different markets to get closer until they are exactly the same and there is no room for arbitrage. Using the same example as mentioned above, assume that a growing number of people discover the price difference between Exchange A and Exchange B, and start to constantly sell the currency on Exchange A and buy it on Exchange B. This leads to a lower price for the currency on Exchange A and a higher price on Exchange B, until the price of the currency on both exchanges is the same and investors can't profit due to price discrepancies.
The term “spot-futures” in “spot-futures arbitrage” refers to perpetual futures and spot. Combined with the above interpretation of arbitrage, spot-futures arbitrage is a trading behavior that utilizes the price difference between ordered futures and spot to arbitrage. As the basis for spot-futures arbitrage, perpetual futures only exist in the cryptocurrency market. So, the term spot-futures arbitrage we are talking about today is actually an arbitrage operation that exists only in the cryptocurrency market. The “low risky, high yield” properties also stem from the perpetual contract in cryptocurrency markets.
So, what is a perpetual contract?
Everything you need to know about a perpetual contract can be found in this article (https://www.gate.com/help/futures/perpetual/16697). A brief summary is that the perpetual contracts are similar to traditional futures, but without an expiration date. Those who are bullish on the price of the currency will make long trades and buy contracts with a high price, while those who are bearish on the price will make short trades and buy low. In traditional contracts, the contract price will gradually get close to the spot price as the delivery date approaches. Perpetual contracts without expiration dates never settle in the traditional sense. To avoid excessive deviations between perpetual contract prices and spot prices, a system of funding rate was devised to link the price of perpetual contracts to the spot price.
The principle behind the funding rate mechanism is that when too many participants and funds in perpetual contracts are operating on one side, a certain funding rate needs to be paid to the counterparty in order to stimulate an increase in the number of counterparty participants and the amount of investments. To be specific:
1. When the market is dominated by traders who are trading long, they need to pay proportional funding fees to traders who are trading short.
2. When the market is dominated by traders who are trading short, they need to pay proportionate funding fees to traders who trade long.
3. When the market is balanced between the long and short sides, the long or short positions don’t have to pay fees to each other.
The percentage of funds paid to the counterparty is the funding rate. The funding fee is the arbitrage profit earned by investors who execute spot-futures arbitrage trading.
Funding Rate Arbitrage
Now that we know what funding rates and funding fees are, how does spot-futures arbitrage help us earn funding fees with low or barely any risk? Before introducing the funding fee arbitrage, a few more points need to be made.
Firstly, the funding rate is settled every 8 hours and will change 3 times a day.
Secondly, the positive and negative funding rates represent the direction of payment, with the positive funding rate showing that traders who are long pay for short positions and the negative one signifying that traders who are short pay for long.
Thirdly, considering that the funding rate for perpetual contracts in the cryptocurrency market is positive most of the time, perpetual contract traders who are long tend to pay fees for short positions in the vast majority of cases.
The following is an example of how spot-futures arbitrage works with BTC spot and perpetual contracts. If the market funding rate is 0.03% and remains unchanged, the arbitrageur will buy spot and short perpetual contracts. Assuming that the current BTC price is 5000 USDT and the investor makes spot-futures arbitrage with an investment of 10,000 USDT with a strategy running time of 365 days:
Firstly, the total funds (10,000 USDT) are divided into two equal parts. Buying 1 BTC (5000 USDT) and shorting 1 BTC in the perpetual contracts markets with 5000 USDT. (without leverage)
Secondly, after shorting the perpetual contract, the investor will get 1.5 USDT.
(1*5000*0.03%=1.5USDT)
Thirdly, during the time the strategy is running, the investor can receive 1095 times of their earnings(365*3=1095; 3 times a day), with a total return of 1642.5 USDT (1095*1.5=1642.5). And the annualized return can reach 16.425%(1642.5/10000*100%).
Users can earn easily using spot-futures arbitrage strategy with the help of Gate Copy Trading, instead of buying spot and contracts themselves.
Low-risk Doesn't Mean No-risk!
Although the spot-futures arbitrage strategy enjoys a low-risk nature, it is not a completely risk-free investment approach. In some extreme situations, it can also result in losses to investors. The main risks are credited to:
1. A change in the direction of the funding rate - When the direction of the funding rate changes during the operation of the spot-futures arbitrage strategy, investors may suffer from losses due to the change from being a recipient of funding fees to a payer. The good news is that the direction of funding rates on Gate is very stable and changes in the direction of funding rates are rare. Occasional losses caused by changes in funding rates can be compensated by the next funding fees.
2. Liquidation - The spot-futures arbitrage strategy requires the use of perpetual contracts to establish a position that involves the use of leverage. When the price of a currency changes significantly, you may get liquidated on your position. In order to reduce this kind of risk, Gate limits the use of leverage in the spot-futures arbitrage strategy. Users can only utilize up to 3x leverage when opening a position.
Use spot-futures arbitrage with one click
Gate Copy Trading has added a strategy — spot-futures arbitrage, which allows users to perform spot-futures arbitrage trading as follows:
1. Go to “Copy Trading” and tap “Strategies Template”.
2. Locate “Spot-Futures Arbitrage”
3. Set parameters
Firstly, you need to select the trading pair for your spot-futures arbitrage strategy.
You can check out this page (https://www.gate.com/cn/futures_info_new/futures/usdt/BTC_USDT#realtimefeehistory) to learn more about the historical funding rate of currencies to be selected and their changes.
Secondly, input the total investment amount. You only need to invest USDT to make the spot-futures arbitrage, without buying the spot.
Lastly, set the leverage. 1x leverage means no leverage is required for the contract, and users can use up to 3x leverage.
Gate reserves the final right to interpret the product.
