How to Market Make Bitcoin Derivatives Lesson 2

In Lesson 1, I described how to calculate a two-way quote, dynamically hedge, and match the settlement for an ETC7D futures contract. In this lesson, I will discuss how to calculate Basis and Skew, and how to apply these to your two-way quotes.

Calculating Basis

To calculate the future value of any currency pair, you need to know the cost to borrow and lend the home and foreign currencies. The underlying currency of ETC7D is the ETC/XBT exchange rate. Assume that as a market maker you only own Bitcoin and not any other currency.

To buy ETC, you must sell XBT that you own. That XBT has an opportunity cost of capital. If you were to borrow this Bitcoin from another party to fund your business, how much would it cost?

To sell ETC, you must borrow it. There are two ways this is accomplished. For more well established digital currencies, spot exchanges like Poloniex will operate a borrow market. You can automatically pledge Bitcoin as collateral and borrow ETC at the market interest rate when you wish to short it.

If margin trading is not available, you need to borrow it from another trader. The other party will lend you ETC for a period of time at a rate of interest.

Using Covered Interest Rate Parity, we can calculate the Basis.

Basis = (1 + XBTr * t) / (1 + ETCr * t) – 1

XBTr = Bitcoin annualised interest rate

ETCr = Ether Classic annualised interest rate

t = Time in years

In practical terms, we ignore the opportunity cost of XBT. You can compensate for that by increasing your spread profit margin. As a market maker, you are concerned about how much you will pay to short ETC.

Assume it costs you 50% per annum to borrow ETC.

Basis for 7-day Future = 1 / (1 + 50% * 7/365) – 1 = -0.95%

If the spot price is 0.02 XBT, translate that Basis into points.

-0.95% * 0.02 XBT = -0.00019 XBT

ETC7D Quote Mid = Spot + Basis = 0.02 XBT – 0.00019 XBT = 0.01981 XBT

You have lowered your mid price. This will compensate you in the event someone sells to you. If you become long ETC7D, you will have to short ETC and pay the borrow fee.

Calculating Skew

You don’t have infinite capital. Left unchecked, you could build up a large long or short position in ETC7D. Your goal is to capture two-way flow so that you earn half of your quoted spread.

If someone continues selling into your bids, you want to progressively lower your quotes. If someone continues buying your asks, you want to progressively raise your quotes. A simple example will help illustrate the concept.

Assume you quote a two-way market of 10 / 11 for 1 contract each side. The total amount you are quoting on each side is 1 contract; I will call your Total Size Quoted. The bid / ask spread is 10%, half of that spread is 5%; I will call this your Weighted Average Half Spread.

Skew = (Change in Position / Total Size Quoted) * Weighted Average Half Spread * -1

Your position changed by +1.

Skew = (1 / 1) * 5% * -1 = -5%

You originally had a mid price of 10.5. Assume that the mid price represented the spot price.

New Mid Price = Spot + Skew = 10.5 * (1 – 5%) = 9.98

New Bid Price = 9.98 * (1 – 5%) = 9.48

New Ask Price = 9.98 * (1 + 5%) = 10.47

Combining Basis and Skew

Before you begin quoting, you will calculate the Basis. You will do this calculation based on how expensive it is for you to borrow the home currency.

Then while quoting, your trading program will adjust the Skew based on whether traders buy or sell from you.

Quote Mid Price = Spot Price + Basis + Skew

Using these two concepts, you cover your cost of funds, and manage your inventory.

In Lesson 3, I will explain how to handle Auto-Deleveraging events, and other advanced topics. To view the BitMEX sample market making bot, please visit Github.

BitMEX Arbitrage Lesson 4 Webinar

Topics covered in Lesson 4:

  • Delta
  • Theta
  • Bitcoin Value of 1%
  • Portfolio Risk Management

The Webinar will air Thursday 28 January 03:00 GMT.

Webinar Link

You can listen live, and after the presentation ask questions. If you are unable to tune in, a recording will be made available shortly after the broadcast is finished.

Supporting Materials:

BitMEX Arbitrage Lesson 3 Webinar

Topics covered in Lesson 3:

  • Constructing Futures Basis Term Structure
  • Curve Roll Down
  • Curve Directional Trades

The Webinar will air Thursday 21 January 03:00 GMT.

Webinar Link

You can listen live, and after the presentation ask questions. If you are unable to tune in, a recording will be made available shortly after the broadcast is finished.

Supporting Materials:

BitMEX Arbitrage Lesson 2 Webinar

Topics covered in Lesson 2:

  • Cash and Carry Arbitrage
  • Calendar Spreads
  • Basic Volatility Arbitrage

The Webinar will air Wednesday 13 January 03:00 GMT.

Webinar Link

You can listen live, and after the presentation ask questions. If you are unable to tune in, a recording will be made available shortly after the broadcast is finished.

Supporting Materials:

Bitlicense: Same Same But Different

Don Lawsky graced the plebes with a press conference last night and announced the final version of the long awaited Bitlicense. The final draft is same same but different. The core requirements remain the same. Some of the more ridiculous provisions were struck. The initial reaction by many was that the revised version is a necessary evil and slightly better than expected.

Those expecting a blockbuster announcement of a major financial institution that now will be accepting or trading Bitcoin were disappointed. Bitcoiners need to realise that large financial institutions do not care about regulations. If it was profitable to trade and accept Bitcoin, they would already be doing it.

Monetary historians will remember how and why the Eurodollar market originated in London. Since FDR’s ascension to power in the 1930’s, America has been a centrally planned and controlled economy. The free market exists in very few arenas. Banking swung from a free for all, to a collection of heavily regulated legacy banks. There were interest rate ceilings and severe restrictions on the issuance of commercial paper and foreign exchange trading. American banks (who loved the regulations so much) decided to issue dollar denominated debt without restrictions from London. The Eurodollar market arose in the 1950’s to escape onerous US regulations. Morgan Stanley was one of the most active players in the new space.

From Investopedia:

U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks. By locating outside of the United States, eurodollars escape regulation by the Federal Reserve Board.

Everyone else followed and the global liquidity centre for FX and derivatives became London. To this day London regulations on derivatives of all sorts are much lighter than American ones. Remember the “London Whale”? He was the trader responsible for JPM $6 billion dollar loss on exotic credit derivatives a few years back. His whole team sat out of London, far away from the prying eyes of the coterie of ineffective paid-off American regulators. Most large financial institutions book and house derivatives on London banking chains.

The Bitcoin community needs to wake up. Large financial institutions will get involved in Bitcoin when there is enough money in it for them. Hopefully that happens soon. Regulations are only meant to extract rent from certain industries, and trick a gullible public that their over paid government overloads actually care about their well being.

The lack of a price pop after the Bitlicense announcement is worrying. Expect the downtrend to continue, and a retest of $220. Sell XBUM15 with a downside target price of $220. If $220 breaks, look to cover at $213.

Case Study: Using Bitcoin Derivatives in Global Trade

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One of the stated goals of BitMEX is to allow Bitcoin to be used in global trade by eliminating the price volatility. Two entrepreneurs in Kenya and Hong Kong are using Bitcoin and BitMEX futures contracts to import goods into East Africa from China.

China produces goods cheaper and in bigger quantities than anywhere else globally. Kenya is one of Africa’s richest countries and consumes many Chinese finished goods. For Kenyan SMEs (Small and Medium-sized Entrepreneurs), procuring goods to resell locally can be troublesome and quite expensive. This is mainly due to the fact it is hard for them to settle payment between the Kenyan Shilling (KES) and Renminbi (CNY). Multinational companies can cheaply settle cash flows between Kenya and China, and manufacturers might even give them credit, but for SMEs the inability to settle payment means they must buy products second hand from parallel traders at large premiums. This mostly comes down to banks supporting larger organisations over smaller ones.

Robin Omwega is the head of Kenyan IT services firm Wageni Tech and also a Bitcoin enthusiast. Joseph Wang is the founder of Bitquant, a quantitative research firm focusing on Bitcoin and other financial markets. He is also a former JP Morgan quantitative trader. They met via a global Bitcoin chat room and devised a way to help supply East Africa with more affordable goods from China. They found that Bitcoin can serve as the settlement mechanism for payments between them, and have began a trading partnership between Kenya and Hong Kong / China.

The biggest issue with using Bitcoin is the price volatility. In the time between when Robin sends Joseph payment for goods in Bitcoin and they arrive in Kenya, the price can fluctuate wildly and cause losses for Joseph. To eliminate the price risk, Joseph hedges Bitcoin payments by selling BitMEX futures contracts that lock in the USD value.

Robin and Joseph have started by importing USB drives. Robin places an order with Joseph for the drives. Joseph selects a Chinese manufacturer with whom he has formed a business relationship. Joseph pays the manufacturer in CNY and now needs payment from Robin. Robin sends Bitcoin equaling the value of the purchase to Joseph, and the coins are locked in escrow using Bitrated. While they are in escrow, Joseph can’t sell the Bitcoin for CNY and needs to hedge. Joseph goes onto BitMEX and sells futures contracts locking in the USD value of the Bitcoin. Since he can trade on leverage, Joseph only needs to deposit as little as 30% of the value he wants to hedge. The USDCNY exchange rate is quite stable and Joseph isn’t worried about the price fluctuations. Once Joseph receives the goods in Hong Kong, he inspects them and ships them to Robin in Kenya. Robin receives the USB drives and releases the Bitcoin from escrow to Joseph. Joseph then buys back the futures contracts on BitMEX, and exchanges the Bitcoin into CNY on a spot exchange.

Robin and Joseph have been able to use Bitcoin as a clearing mechanism and eliminated the price risk using BitMEX derivatives. Without the use of futures contracts, Joseph exposes his business to price volatility and either must pass this cost onto Robin or not do the deal at all.

BitMEX derivatives are unique in the Bitcoin landscape as they are the only futures that guarantee settlement without socialized losses or clawbacks. With this guarantee, traders around the globe can hedge without fear that fluctuating prices – or other traders’ liquidations – will cause them to lose money.

BVOLG15: A Postmortem

BitMEX launched the world’s first Bitcoin historical volatility futures contract called BVOLG15. The contract settles at the BitMEX 30 Day Historical Volatility Index (.BVOL Index) price. This post will serve as a postmortem describing the trading behavior of the first contract, and hopefully further educate traders as to how they can incorporate BitMEX volatility futures contracts into their portfolios.

.BVOL Index measures the annualised standard deviation of the % move between Time Weighted Average Price (TWAP) calculations done on Bitfinex every day from 10:00 GMT to 12:00 GMT. Because .BVOL Index comprises 30 days of price changes, there must be a total of 31 price increments. For BVOLG15, that meant the observation period lasted from 27 January 2015 to 27 February 2015 inclusive.

BVOLG15 was listed on 5 January 2015, meaning for three weeks traders were placing bets purely on their expectations of future realised volatility. Each day after 27 January 2015, a clearer picture was formed as to where 30 day volatility would realise by expiry.


The above graph shows a comparison of .BVOL Index and BVOLG15. BVOLG15 performed as expected. If there are N days until expiry, BVOLG15’s price is composed of N days of realised volatility expectations and (30 – N) days of realised volatility. Even as .BVOL spiked above 150% realised volatility, BVOLG15 did not rise to the same degree because the market did not expect that level of volatility to persist in the future. This is also evident in the volatility of volatility for both .BVOL Index and BVOLG15. The annualised volatility of .BVOL Index and BVOLG15 was 260% and 140% respectively.

Traders who believe they can accurately forecast realised volatility should utilise BVOL futures contracts. Intra-month they discount future realised volatility effectively. Traders need not hold until expiry, but can effectively move in and out of positions as expectations of future realised volatility changes.
This is a link to an Excel spreadsheet showing the .BVOL and BVOLG15 data that was used in the calculations and graph presented in this post.

Crypto Trader Daily – 15 February 2015

Price Action

Early morning Asia time, the price began its ascent first past $260, and then in the evening $270 was almost taken out on Bitfinex. Shortly afterwards a sharp correction brought the price down to the low $250s. Since the 11th, Bitcoin has risen 18%. The rally has been on relatively low volumes as it is a bank holiday weekend in the US, and China begins the year of the Ram this week. A healthy correction to the mid $240s is in order.


Trade Ideas

Continue to fade this rally down to the low $240s. Begin accumulating a long position as the price consolidates. For a medium term trade horizon, use XBTG15 (27 February 2015) to amass a long position.


In the News

Bter offline due to “security check” (Reddit)

Full Flush Poker now allows Bitcoin deposits (Professional RakeBack)


Crypto Trader Daily – 14 February 2014

Price Action

$240 was taken and the price promptly shot up above $250. The retrace has taken the price down to the low $240’s. The rally looks healthy with higher highs on rising volumes. $260 could be tested before the weekend is over.


Trade Ideas

Accumulate Bitcoin in the low $240’s. Look for a retest of $250 and a possible rise to $260 in the next 48 hours. Use XBTG15 (27 February 2015 Futures Contract) to express this view.


In The News

Bitcoin and (CoinDesk)


CNN’s Morgan Spurlock ‘Survives on Bitcoin’ for a Week (Inside Bitcoins)

Crypto Trader Daily – 13 February 2015

Price Action

Bitcoin broke out of the $220’s today with a jump above $230. Speculation about Google and Poker Stars possible integration of Bitcoin into its payment platform is cited by some traders as the catalyst for the move. The price is pushing up against $240. A break above there and we may see a retest of $250.


Trade Ideas

Buy XBU24H (Daily Inverse Future) in anticipation for a punch above $240. Quickly close the long position if the price fades below $230.


In The News

Poker Stars to accept Bitcoin? (Coin Fire)

Google to integrate Bitcoin into its payments system? (Crypto Coins News)

Former US Treasury Secretary weighs in on Bitcoin (CoinDesk)

BitMEX Launches Inverse Daily Futures Contract

BitMEX is proud to announce the launch of a fast-moving inverse daily settling futures contract called XBU24H. XBU24H is live and trading.

XBU24H enjoys BitMEX’s lowest fee structure yet: regardless of whether or not you are on the Trader or Hedger fee schedule, XBU24H is a 0% maker / 0.03% taker fee structure with no insurance fees.

XBU24H is a continuously listed contract that settles daily. It is designed to be traded quickly and easily. It is similar to our longer-term XBU contracts, but the contract size is US$1 instead of US$100.

Contract Details

Listing Date: Today, 2 February 2015 at 12:00 GMT

Underlying: BitMEX Bitcoin / USD .XBT30M Index, this index is used for settling daily futures contracts

Maturity: Daily at 12:00 GMT (ticker: XBU24H)

Quoting Method: USD

Contract Value: 1 USD of Bitcoin

Settlement: The BitMEX .XBT30M Index, the index is a daily measurement of 30-minute Time Weighted Average Price (TWAP) from 11:30 to 12:00 GMT on Bitfinex.

Margin & PNL Currency: Bitcoin

Leverage: Up to 5x

Trading Fees: Maker 0.00% / Taker 0.03%


Commercial Hedgers

XBU24H allows commercial hedgers to lock in the USD price of Bitcoin for short term hedges. An example is someone who wished to hedge the Bitcoin price movement during network confirmations. XBU24H will mimic the spot price movements due to the daily expiry.


XBU24H allows speculators to trade short term Bitcoin spot price movements with leverage. The contract size is lowered to US$1 to allow traders to trade exactly the quantities they desire. Remember that on all crypto derivatives exchanges, trading fractional contracts is not possible. A smaller contract means more flexibility.

Bitcoin Volatility As An Asset Class

Volatility is the measurement of a financial instrument’s price variation over time. Volatility as an asset class refers to isolating this variable and trading it as a standalone product. Usually volatility is isolated by the trading of delta hedged call and put options. Currently Bitcoin does not have a liquid options market so this method of isolation does not exist. However this does not preclude the existence of tradable Bitcoin volatility.

BitMEX is leading the market in innovations around the trading of volatility absent an options market. The BitMEX 30 Day Historical Volatility Index futures contract (BVOL) and the XBT vs. XBU pseudo volatility allow investors to trade Bitcoin volatility on BitMEX.

Why Trade Volatility?

Trading volatility allows investors to profit from the price movements or lack thereof. They need not predict the direction of the Bitcoin price. Event driven traders can profit from price gyrations after major news or market events which increase volatility. Conversely investors anticipating periods of relative inactively can sell volatility and profit from a quiet or sideways market. The addition of Bitcoin volatility adds another weapon to savvy investors’ alpha arsenal.

BitMEX 30 Day Historical Volatility Index Futures (BVOL)

On 5 January 2015, BitMEX launched the world’s first historical volatility index future with the ticker BVOL. The futures contract allows investors to bet on where 30 day volatility will realise. The BitMEX 30 Day Historical Volatility Index tracks the rolling 30 day realised volatility by using daily 10:00 GMT to 12:00 GMT 1 minute Time Weighted Average Prices on Bitfinex for Bitcoin / USD. The product is quoted in annualized volatility % points and investors make or lose 0.01 Bitcoin per 1% point move.

Forward Starting Historical Volatility

The BVOL futures contracts expire on the previous 30 days realised volatility. However, the contracts are tradable before the 30 day observation period starts. This allows investors to trade their expectation of where future historical volatility will realise. If it is 1 January 2015 and an investor is trading the BVOLG15 contract (27 February 2015 expiry), the observation period does not begin until 29 January 2015 (30 days prior to expiry). The price of BVOLG15 reflects the market’s view on where historical volatility will be in the future.

This has interesting implications for the pricing of other Bitcoin derivatives. Bitcoin by some is viewed as a long dated call option. The most crucial component to valuing an option is the volatility of the underlying asset. On a longer term view, higher the forward expectations of Bitcoin volatility lead to more valuable call options and possibly Bitcoin itself.

If there are major market events that will occur at specific dates in the future, the forward expectations of volatility gauge how impactful the market believes these events to be. An investor’s view of the over or under appreciation of the magnitude of the event leads to trading opportunities through the volatility component.

As liquidity and interest grows in the BVOL futures contracts, we will list longer dated maturities. Once complete, investors will have a term structure for expected future Bitcoin historic volatility. This is very useful for options traders pricing longer dated maturities. Using BVOL futures contracts as guide posts, options traders will be able to make markets in over the counter (OTC) options at tighter spreads and larger size.

Once the observation period has begun for a particular BVOL futures contract interesting arbitrage opportunities present themselves. Every day that passes there is more information about where the 30 day historical volatility will realise for a particular contract. BVOL prices too high or too low can be sold or bought vs. a knowledge of the magnitude of impact future prices can mathematically have on realised volatility.

XBT vs. XBU Pseudo Volatility

BitMEX offers two types of futures contracts, the XBT and XBU chain. The XBT chain is quoted in USD but has a XBT multiplier, a quanto style future. Therefore, buyers of XBT chain contracts have unlimited upside, but can only lose 100%. The XBU chain is worth $100 of Bitcoin at all times and is quoted in USD, an inverse style future. Therefore, sellers of XBU chain contracts have unlimited profit potential on the downside, but can only lose 100% if the price moves higher. The XBT chain is an X function, the XBU chain is a 1/X function. All else being equal, for a given maturity the XBT chain should trade at a greater price than the XBU chain. In USD terms multply each function again by X (Bitcoin / USD exchange rate), what is left is XBT – XBU = X * (X – 1/X) = X2 – 1.

Prices observed for the XBTH15 and XBUH15 contract confirm this theory. XBTH15 has been trading at a $25-$40 premium to XBUH15 on BitMEX. Because both contracts have the same maturity, this difference represents a pseudo strangle. A strangle is an options strategy where one buys a put and a call with the put having a lower strike price than the call, and both options having the same maturity. This is a volatility play; buyers of the strangle hope that realised is greater than implied volatility.

Traders who believe the realised volatility will be less than the pseudo implied volatility should sell XBT and buy XBU; those who believe the opposite should buy XBT and sell XBU. For sellers of pseudo volatility, if spot trades outside the profitable range, losses will accumulate in a non-linear fashion.

In the absence of traditional options straddles and strangles, pseudo volatility is a way for traders to express their views on implied volatility for a particular maturity.

Combining BVOL and XBT vs. XBU Pseudo Volatility

The difference between same maturity pseudo implied volatility and realised volatility through BVOL presents trading opportunities. If pseudo implied volatility is much higher than BVOL expected realised volatility, sell pseudo implied volatility (sell XBT, buy XBU) and buy BVOL. If pseudo implied volatility is lower than BVOL expected realised volatility, buy pseudo implied volatility (buy XBT, sell XBU) and sell BVOL.

The addition of volatility products on BitMEX has added three new trading strategies for investors. All of which do not call for the prediction of the direction of the Bitcoin / USD exchange rate.