This is the first part in OKX's research series on Nitro Spreads, which enables institutional investors to implement a variety of basis trading strategies with dedicated spread order book liquidity for both legs of a transaction.
Market backdrop
The cryptocurrency market has increasingly been under the spotlight of both institutional investors and the general public in recent months. With a flurry of developments announced by government authorities and major institutional investors in the cryptocurrency space, Bitcoin has emerged as the top-performing asset class of the year, delivering a year-to-date return of over 80%.
Taking long delta exposures in the cryptocurrency market may seem to be generating solid returns, however, the reality is that timing the market remains a significant challenge due to the high volatility of this asset class. 98% of year-to-date returns are attributed to 8 trading days (out of 180). This underscores the unpredictable nature of the crypto market and the challenge of timing stable returns.
Source: OKX
On the volatility front, the cryptocurrency market has experienced a notable shift over the past few weeks, following a period (April to June 2023) of low volatility. This has been accompanied by a surge in trading volume, indicating heightened activity in the market. Specifically, we've observed a steepening contango of the term structure of implied volatility for Bitcoin at-the-money options, which suggests that market participants are anticipating an increase in volatility in the future.
There are several factors in play - with the primary one being the growing uncertainty around regulatory developments in the cryptocurrency space, with authorities around the world taking divergent approaches to this emerging asset class. Additionally, the market continues to focus on the rate decisions from Federal Reserve, which could have significant implications for the broader financial markets. Finally, institutional participants have become increasingly involved in the cryptocurrency market, and this is expected to influence market dynamics as well.
Source: Laevitas
Given these factors, it is reasonable to expect that the cryptocurrency market will continue to experience unexpected bouts of volatility in the coming months. As a result, for cryptocurrency traders who understand and can bear the risks of trading, a market-neutral strategy could offer a more balanced approach, as it can help mitigate risks associated with sudden market movements and offer a more stable source of returns if execute correctly.
Introduction to spread trading strategy
There are several types of market-neutral strategies that traders can implement to generate stable returns. Each of them takes a different approach and requires different data and skill sets, trading instruments and platforms. One of the most commonly seen in cryptocurrency trading is spread trading. Spread trading is a market-neutral trading strategy that involves taking advantage of the price differential (spread) between an asset's price on different instruments. In the world of cryptocurrency, there are two types of spread trading strategies that are most commonly seen — basis trading and calendar spreads.
Basis trading
Basis trading is a popular strategy to exploit the price differential between the spot and futures markets. Basis refers to the difference between the futures prices minus the spot prices. If the basis is positive, the futures prices are higher than the spot prices, and vice versa. This provides a trading opportunity for traders to go long or short the Basis. For example, the trader wants to short the basis when the basis is expected to go down - this requires the trader to simultaneously purchase the asset in the spot market and short the corresponding amount of the futures contract. By holding these two legs until the futures contract's expiry, this strategy yields a return from the basis. This is also known as the cash-and-carry trade.
In cryptocurrency, perpetual swap is a popular type of trading instrument. Perpetual swaps do not have an expiry date and the funding rate mechanism allows traders to carry out basis trading based on the funding rate. When the funding rate is positive, the trader buys spot and short perpetual swaps to receive the funding rate.There are several factors contributing to the price differential between spot and futures/swaps and these are also the key return drivers for Basis trading.
Market preference on instruments (spot vs futures) - Traders may prefer Futures over Spot when they are looking for leveraged exposure and do not want to take custody of the cryptocurrency asset themselves.
Market sentiment - When the market is bullish, there is typically a contango in futures markets (or positive funding rate) due to the expectations of higher prices in the future; On the contrary, there is typically a backwardation in futures markets (or negative funding rate).
Supply and demand imbalances across exchanges - The price of spot and futures (perpetual) varies between different exchanges due to imbalances in supply and demand of platform traders' behavior.
Market liquidity - In a market with low liquidity, the wider bid-ask spread would lead to a larger basis and more volatility in the funding rate.
Interest rate differential - A high-interest rate differential between two cryptocurrencies can lead to a positive basis in cryptocurrency trading, where the futures price of the higher-yielding cryptocurrency exceeds the spot price to account for the additional interest earned by holding the position until the expiration date.
Source: Laevitas
Calendar spreads
A calendar spread refers to buying and selling two futures contracts simultaneously with the same underlying cryptocurrency. The major difference between calendar spreads and basis trading is that both legs of the trade are futures while basis trading consists of one spot and one future. Similar to basis trading, a calendar spread can profit from the difference between the two futures contracts with different expiration dates. Moreover, it can also be an effective tool for traders to carry out rollover for their futures contract position.
Client insights: Starboard Digital Strategies
OKX offers the world's most powerful suite of institutional crypto trading solutions and is the preferred platform for institutional traders across the globe, including Starboard Digital Strategies (SDS). Launched in March 2021, Starboard Digital Strategies (SDS) is a fully institutional-grade hedge fund which executes market-neutral investment strategies in derivative instruments with digital currencies underlying.
The fund is a consistent source of excess alpha for investors willing to diversify their portfolios by adding a digital asset market-neutral strategy. SDS investors benefit from a tested and proven strategy that taps into the opportunities generated by the volatility in digital currencies, and transforms them to uniquely high market-agnostic returns with low standard deviation, totally uncorrelated from any asset class.
SDS' proprietary developed system for opportunity scanning and live portfolio and risk management are coupled with best-of-class automated execution systems and full API connection for direct access with custodians and exchanges. Since its commercial launch on March 2, 2021, SDS has delivered a net return of 46.6% with a daily volatility of under 0.2%, while taking practically zero directional risk.
Since the birth of the derivative instruments for cryptocurrencies, market-neutral strategies have been developed and are being run across various markets. SDS specializes in such strategies as it represents a sophisticated way of generating low-risk, uncorrelated returns. Generating such returns requires a specific skill set such as a sound understanding of both macro and micro conditions, tailormade systems, leverage, speed, and above all strict adherence to being market neutral-disciplined.
Spread trading is a cost-effective way to leverage one’s assets with a good plan and execution. Although the trading strategy is market-neutral, execution risk can be material and costly. In particular, spread trading requires atomic execution between the two legs to ensure market-neutral exposure. Liquidity also plays an important role in ensuring low slippage on execution for both legs."Success in spread trading does require low trading fees, great execution, but above all, getting the market's perception of risk appetite correct" - Nikolas from Starboard Digital Strategies
How can Nitro Spreads help as a product solution?
OKX has recently launched Nitro Spreads in response to growing demand from institutional traders. Nitro Spreads enables a variety of basis trading strategies with dedicated spread order book liquidity for both legs. Via an easy-to-use interface, traders can employ popular delta one spread strategies. Nitro Spreads includes a range of features to assist traders in achieving success in spread trading, including:
Lower trading fees: For VIP users, fees for Nitro Spreads are 50% lower compared to executing them as two individual legs in the central orderbook.
Reduce execution risk: Trades can execute a 2-leg basis trading strategy in just 1 click. The spread is clearly defined and guaranteed, with no associated leg risk. Additionally, unexpected price slippage will be minimized by leveraging the superior liquidity and low latency of OKX's platform.
Higher capital efficiency: The Initial Margin Requirement (IMR) to execute spread trading is lowered on Nitro Spreads than the central orderbook. As the delta risks of the two legs offset each other on Nitro Spreads, traders are no longer required to post IMR for both trades, offering higher capital efficiency.
Nitro Spreads is one of the only basis trading tools in the crypto market in which the two legs of the trade are executed in an orderbook fashion, eliminating leg risk between markets. Selected institutional clients who applied for early access via the Liquid Marketplace website can now use Nitro Spreads; wider access will be available to other institutional clients starting 25 July.
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