Calling the Curve

Arthur Hayes

The BitMEX Bitcoin / USD 28 December 2018 futures contract, XBTZ18, recently began trading. The following trade ideas assume that spot in the short term will continue to fall and bottom in 3Q2018, and then aggressively rebound into 4Q2018. This scenario also assumes that trader sentiment will not fall out and enter a protracted bear market.

However, if you have very high conviction in that scenario, the riskiest and potentially most profitable strategy would be to:

  1. Go short XBTU18 from now until you believe Bitcoin has bottomed.
  2. Cover the short XBTU18, and then go long XBTZ18.

The reason to go short the 3m initially is that it should be more responsive to spot movements due to its lower time value. It is also more liquid so panicked speculators and hedgers will use that futures contract. Its annualised basis should trade at a steeper discount than XBTZ18.

You go long XBTZ18 on the rebound because it has more time value. If the market does perform as you expect, speculators will bid up the backend of the curve. A lot of things can happen by the end of December. Given that Bitcoin is a call option, the future implied volatility has a greater probability of causing the price to rise rather than fall. The more time value housed in the instrument you are trading, the better change the long convexity can work in your favour.

If you believe this a credible sequence of events, but want to reduce risk, a spread trade is advisable. The reduced risk comes at a the cost of reduced profit potential.

  1. Go short XBTU18 vs. long XBTZ18 from now until you believe Bitcoin has bottomed.
  2. Replace the above short XBTU18 with a short on XBTUSD

Because you expect the sell pressure to happen at the short-end of the curve, the term structure will steepen causing the profit made on the short XBTU18 position to offset losses on the long XBTZ18 position. The term structure chart shown above shows the current curvature of the BitMEX Bitcoin / USD futures markets. It is relatively flat, which indicates now is the time to enter into this spread trade.

This is a price neutral trade; however, be aware that each position is margined separately. Unrealised profit from the short XBTU18 position cannot be used to offset unrealised losses from the long XBTZ18 position.
The second trade is a funding plus long 6m basis trade. As the market rebounds, the swap will be pushed into a premium which means shorts will receive funding. The long end of the curve will also get bid up in annualised basis terms due to the greater time value. You earn money from the swap funding, and futures basis appreciation. Again this trade is price neutral, and you must be cognizant of each positions’ margin.
The reason why I prefer the use of spread trades to express directional moves is that if my prediction is wrong, it does not destroy my capital base. The more conviction around the prediction, the more leverage I employ on each leg to juice up my return on equity.