Arbitrage Made Easy, Lesson 1

The Arbitrage Made Easy lessons will present simple yet profitable arbitrage strategies that can be employed by traders using a combination of spot Bitcoin trading and BitMEX derivatives contracts. The Bitcoin/USD exchange rate will be referred to using the symbol XBTUSD.

Lesson 1 will focus on the arbitrage of price differentials between spot XBT exchanges.

After spending some time trading XBT, traders will notice that sometimes there are large differences between exchanges. Savvy traders can capture these price differentials in a riskless manner. This lesson will assume that the trader’s home currency is USD. Therefore, the trader wants zero risk in USD terms. Traders will use a portfolio of USD and XBT to capture arbitrage opportunities risklessly.

During this lesson we will refer to the “cheap exchange” as exchange A, and the “expensive exchange” as exchange B. The goal as with any trade is to buy low on exchange A, and sell high on exchange B.

Step 1: Construct a Portfolio of Half USD and Half XBT

The arbitraging of spot exchange requires traders to buy XBT cheaply on exchange A, and sell XBT expensive on exchange B simultaneously. If a trader started with just USD the following steps would have to be taken to conduct the arbitrage:

  1. Wire USD to exchange A
  2. Sell USD buy XBT
  3. Transfer XBT to exchange B, wait for 1-6 confirmations
  4. Sell XBT for USD on exchange B
  5. Remit USD from exchange B to home bank account
  6. Repeat

There are several problems with that trade flow. Wiring USD can take upwards of 5 business days depending on the bank and country. By the time the funds reach exchange A, the arbitrage opportunity could have disappeared. In step 3, the price of XBT could move against the trader before he is able to sell on exchange B.

The optimal structure would be to have a portfolio of USD and XBT spread out across the relevant exchanges. When an opportunity presents itself, traders can act immediately and capture the arbitrage before it evaporates.

Going forward a XBT spot price of $500 will be assumed. A portfolio of $5,000 and 10 XBT has been constructed. The total portfolio value is $10,000 = $5,000 + 10 XBT * $500.

Step 2: Sell XBT Futures Contracts to Eliminate Price Risk

The home currency is USD, traders do not want to have any exposure to XBT exchange rate fluctuations. Trading BitMEX futures contracts is the best way to eliminate currency risk. BitMEX offers a futures contract that locks in the future USD value of Bitcoin, called the XBU series.

Step 2a: Selling XBUU14 Futures Contracts

Each XBUU14 (BitMEX USD / Bitcoin September 26, 2014) is worth $100 of Bitcoin. The underlying is the XBTUSD spot price. For this lesson, the current XBTUSD price is $500. The current price of the XBUU14 contract is $500. To determine the proper amount of contracts to sell, the trader should consider the USD value of XBT that he wishes to hedge. The current USD value of the 10 XBT held is $5,000 = $500 * 10 XBT. The portfolio needs to sell 50 contracts = $5,000 / $100.

Now the sample portfolio looks as follows:

$5,000 cash

10 physical Bitcoin

Short 50 XBUU14 contracts

The below table shows the USD value of the portfolio as spot XBTUSD changes:

XBTUSD USD Cash Physical XBT XBT Profit XBUU14 USD Portfolio Value
300 $5,000 10 XBT 7 XBT $10,000
400 $5,000 10 XBT 3 XBT $10,000
500 $5,000 10 XBT 0 XBT $10,000
600 $5,000 10 XBT -2 XBT $10,000
700 $5,000 10 XBT -3 XBT $10,000

Because of the XBUU14 hedge, the portfolio value stays constant at $10,000 no matter the XBTUSD price. Now the Bitcoin price volatility will not affect the returns from this arbitrage strategy.

Step 3a: Full Circle Arbitrage Between Exchanges A and B

Now that the portfolio has been constructed and hedged to eliminate currency risk, it is time to capture riskless profits. Exchange A trades at $480, while exchange B trades at $500. The below steps describe how to arbitrage the two exchanges.

  1. Deposit $5,000 onto exchange A; deposit 7 XBT onto exchange B
  2. Buy 7 XBT on exchange A for a cost of $3,360 = 7 XBT * $480
  3. Simultaneously sell 7 XBT on exchange B and receive $3,500
  4. Withdraw $3,500 from exchange B, then wire $3,500 to exchange A
  5. Transfer 7 XBT from exchange A to B
  6. Repeat

The above trade generated $140 in gross profit. USD deposit and withdrawal fees as well as exchange trading fees must be deducted. The result will be the net profit from this arbitrage trade. The amount of times the portfolio can be churned is limited by the speed of USD wire transfers and the size of price gap between exchange A and B.

Notice that only 7 XBT could be used as working capital for the arbitrage opportunity. This is because BitMEX requires margin to be posted against the short 50 XBUU14 contracts. BitMEX requires an initial margin of 30%, given short 50 XBUU14 contracts are worth 10 XBT (1/$500 * $100 * 50 Contracts), 3 XBT must be deposited as margin with BitMEX leaving 7 XBT for arbitrage purposes.

Step 3b: Exchange A and B Spread Trading

Instead of withdrawing USD from exchange B and transferring again back to exchange A, a trader can play the spread between the two exchanges. Exchange A trades at $480, while exchange B trades at $500. The below steps describe how to spread trade.

  1. Deposit $5,000 onto exchange A; deposit 7 XBT onto exchange B
  2. Buy 7 XBT on exchange A for a cost of $3,360 = 7 XBT * $480
  3. Simultaneously sell 7 XBT on exchange B and receive $3,500
  4. Prices on exchange A and B equalise at $500
  5. Buy 7 XBT on exchange B for a cost of $3,500
  6. Simultaneously sell 7 XBT on exchange A and receive $3,500
  7. Exchange A now contains $5,140
  8. Exchange B now contains 7 XBT
  9. Wait for the spread between A and B to widen again and repeat

The above trade has generated $140 in gross profit. USD deposit and exchange trading fees must be deducted. The result will be the net profit from this arbitrage trade. Spread trading does not require the withdrawal of USD from exchange B and subsequent deposit onto exchange A which reduces fees paid. However, traders must wait for the spread to collapse before the portfolio can be rebalanced.

BitMEX CEO Gives Bitcoin 101 Talk to Rotary Club of Hong Kong

The talk focused on the basics of what Bitcoin is, what problems it solves, and what BitMEX offers. Although many of the attendees knew very little about Bitcoin before the talk, they asked very probing and intelligent questions.

On June 10, 2014, BitMEX CEO Arthur Hayes gave a talk on Bitcoin 101 to the Rotary Club of Hong Kong.  The event was well attended by club members who are very prominent in the Hong Kong business world.

The talk focused on the basics of what Bitcoin is, what problems it solves, and what BitMEX offers. Although many of the attendees knew very little about Bitcoin before the talk, they asked very probing and intelligent questions.

10June2014_Club Meeting_Guest Speaker_Arthur Hayes (2)
BitMEX CEO Arthur Hayes accepts a gift from Terrill L. Frantz the acting president of the Rotary Club of Hong Kong.

Bitcoin Derivatives, How Much Are They Costing You? A Primer On CFDs

Make sure you read the fine print; not all derivatives exchanges and brokers are created equal. You might believe that Bitcoin is going to $10,000 per coin or to $0, but if you are trading CFDs and the market isn’t moving you are going to be up the creek without a paddle.

The next frontier in Bitcoin trading is certainly the derivative space. Traders are actively looking for exchanges that allow them to trade futures, options and other derivatives. A host of FX brokers and exchanges have opened up recently and are offering derivative products. By far the most popular offering is a Contract For Difference (CFD).

According to Investopedia a CFD is:

This is generally an easier method of settlement because losses and gains are paid in cash. CFDs provide investors with the all the benefits and risks of owning a security without actually owning it.

What makes CFDs so popular is the extreme leverage that different brokers will offer clients. As of right now there are CFD brokers offering up to 20x leverage on Bitcoin vs. the US dollar. Unfortunately this enhanced leverage comes a cost, and most likely a very great one that many investors just don’t realize.

To trade a CFD a trader will need to post margin to fund his position. The lower the margin the higher the leverage (e.g. 10% margin requirement leads to 10x leverage). There are two numbers traders need to pay attention to, the initial margin and the maintenance margin. The Initial Margin (IM) is the amount you must deposit with your broker or exchange to initiate a position long or short. The Maintenance Margin (MM) is the bare minimum amount of margin you must have against your portfolio. If you breach this level, your broker or the exchange will margin call you and close all of your open positions.

The margin process is pretty straight forward. So now let’s look at how CFD brokers are making money. Your broker will normally charge you a daily funding charge. Essentially this is the interest rate you pay to borrow money from the broker and gain access to higher leverage. These usually range from 0.10% to 1.00% per day on the total notional of you position. For example, you have a long Bitcoin vs. USD position with a Bitcoin notional of 100 BTC. You deposit 10 BTC for initial margin and if your margin balance drops below 5 BTC you will be margin called and the broker will close you positions. The daily funding charge is 0.50% per day which equals 0.50 BTC per day of fees (0.50% * 100 BTC Notional Position).  If the BTCUSD rate does not move, you will be margin called in 25 days just from the funding charges alone; you have a 5 BTC cushion (10 BTC IM – 5 BTC MM) therefore 5 BTC / 0.50% Daily = 25 days. Talk about a usurious interest rate, you are paying over 500% annualized in interest just to trade this derivative ((1 + 0.005)^365 – 1 = 502%).

Make sure you read the fine print; not all derivatives exchanges and brokers are created equal. You might believe that Bitcoin is going to $10,000 per coin or to $0, but if you are trading CFDs and the market isn’t moving you are going to be up the creek without a paddle.

CEO Arthur Hayes To Speak On Bitcoin Derivatives At Inside Bitcoins Hong Kong

BitMEX CEO Arthur Hayes will be speaking on the 25th of June from 3:00 PM to 3:45 PM on Bitcoin derivatives and the current market structure.

BitMEX CEO Arthur Hayes will be speaking on the 25th of June from 3:00 PM to 3:45 PM on Bitcoin derivatives and the current market structure.

Bitcoin Derivatives: What Are They? And Why We Need Them

While trading volumes on spot exchanges have risen dramatically since early 2013, the derivative market remains nascent and grossly underdeveloped. Many high profile figures in the Bitcoin community have been calling for a liquid derivatives market. This panel will examine what is meant by a Bitcoin derivative, the different uses of derivatives by different market participants, and the benefits to having a liquid and robust market. We will examine the current landscape of derivatives products and help attendees grasp the different uses and risks with trading different types of derivatives. We will also look to the established market of fiat currency derivatives to gauge what sort of market growth is needed to develop a healthy ecosystem.

Inside Bitcoins Hong Kong