http://austeritysucks.com/swapmans-futures-arbitrage-walkthrough.html
Reproduced:
(Totally hypothetical scenario. Not financial advice. Do not do this. I do not endorse this and I'm not responsible for any losses.)
Note: This strategy only works when futures are trading at a premium and for the right type of contract: Inverse Contracts or any derivatives which can lock in the USD value somehow (OKCoin, Bitmex XBU, and CryptoFacilities). XBT (quanto) contract payout structure is different and less effective for arbing because you have to constantly rebalance. For simplicity, assume no fees, no spread, no counterparty risk (no socialized loss), no exchange risk.
Making money arbitraging bitcoin futures is extremely simple. They typically trade at a small premium, and all you have to do, starting with USD, is buy bitcoin at Spot price and sell futures of the same amount at premium price. Seems too easy? Let's go through it in more detail:
- You've got $1000 and spot price is at BTC/USD = $400. Let's say it's a Wednesday morning.
- You look at the Forward curve and notice that the OKCoin weekly futures expires in 2 days and has a $5 premium, trading at $405 (ca 1% delta).
- In two days the futures contracts expire and will settle at Spot price, which is currently lower.
- You see this difference and think: there has to be a way to profit off this, right?
Simple Arbitrage Example Steps
1. Use your $1000 to buy 2.5 bitcoin on OKCoin spot.
2. Move your 2.5 BTC instantly from OKCoin Spot -> Futures
3. Sell 10 Contracts ($1000) short at $405 on Weeklies
And that's it! All you have to do is wait until expiration of the contract and settlement and you guarantee est $10 (ca 1%) profit on this move (ex-fees/spread/etc)
Remember, you must start with fiat, ideally with your USD already on OKCoin. You dont have time to deposit fiat, and USD is your starting point for arb purposes.
Since OKCoin futures are traded using only bitcoin, you have to get the USD into BTC in order to achieve the arbitrage. So either you start with Fiat on OKCoin and buy BTC, or you use USD to buy coin from somewhere else and just send the BTC over to OKCoin Futures. So if you had $1000 in cash and had a buyer who was willing to sell to you at spot, that would be fine too.
http://austeritysucks.com/arbmodel.png
So, find some fast way to get your USD into BTC so you can arb right away; USD = $1000 -> buy 2.5 BTC
Then you move your 2.5btc into the futures side of OKCoin, which credits right away.
On there, you sell 10 contracts ($1000) of BTCUSD1W at $405.
Note that you must use Cross Margin/NonIsolate Martin/Portfolio Margin in order to be fully unlevered and not at risk of margin call.
You have now successfully locked in an arbitrage profit in a trade on OKCoin bitcoin futures. You will earn a positive Pnl of $10-15 under any market conditions, regardless of whether price moons or dooms.
Once Friday comes and the Pnl settles, you can move your ~$10 arbitrage profit (in BTC, remember OKCoin futures are only traded using BTC) from OKCoin Futures -> Spot and sell into USD to secure your profit in USD, or just keep it in BTC.
If you're still scratching your head, analyze what your profit would be under two extreme cases: one where spot price suddenly skyrockets before settlement, and another where it dumps hard right before settlement.
Case 1: BTC/USD jumps from $400 to $500 in 2 days before expiration
Now let's say after 2 days the price of BTC/USD is $500:
Your 2.5btc on deposit at OKCoin is now worth $1250 (2.5 BTC x 500 BTC/USD), however it is in a short position which has lost money:
http://austeritysucks.com/btc500pnl.png
Thus, you don't have 2.5 btc anymore because the 10 contracts on weeklies at $405 you shorted have just expired at $500 and you lost 0.4692 BTC after settlement, so youve got 2.0309 BTC x 500 BTC/USD = $1015.45.
You have profited $15.45 risk-free on your $1000, 1.55% in 2 days, or about 1528% in annualized percentage yield (APY) terms. Ending with: USD = $1015.45 ; BTC = 2.0309
Case 2: BTC/USD drops from $400 to $300 in 2 days before expiration.
Now instead let's imagine that after 2 days the price of BTC/USD is $300, when the weekly futures contract settles at Index (aka spot):
This time your 2.5btc you put over on the futures account is worth $750 (2.5 BTC x 300 BTC/USD). But, your futures position short 10 contracts from $405 has now earned bitcoin because you shorted BTC/USD before it dumped hard and settled at Index (aka spot market):
http://austeritysucks.com/btc300pnl.png
After expiration, you have earned 0.8641 BTC after settlement and in total have 3.3641 BTC x 300 BTC/USD = $1009.23
You have profited $9.23 risk-free on your $1000, 0.92% in 2 days, or about 432% APY. Ending with: USD = $1009.23 ; BTC = 3.3641
Under both cases of extreme price action before expiration, you are earning an arbitrage profit. The reason why you earn $9.23 on one and $15.45 on the other is because theres a small $5 difference in the entry which makes the hedge in this example a little imperfect. But that's because we are working with a small $1,000 example and the minimum contract size is $100, so you can't get a perfectly aligned hedge on such a small level. This is how it works in practice, small difference leads to this small outcome change, but the result is the same: risk-free (minus exchange/etc) arbitrage profit!
Thoughts
- No matter what bitcoin price does, you have earned an arbitrage profit of $10-15 in 2 days using $1000 or 2.5 bitcoin at the start.
- This is what's known as a "delta neutral arbitrage play", meaning you have exploited a price differential that you earn money on regardless of where the spot market changes until expiration
- It may not be as sexy as doubling your money on a move within an hour trading at 20x, but earning 400%+ returns in annual rates on your money with little to no risk is very handsome for the patient traders out there.
- Say you have $100,000 instead of $1,000. Rather than making $10 in a few days on this move, you could make $1,000, in days, with no real risk except exchange drama.
- On OKCoin, it's not that hard to move 1,000 contracts ($100,000 notional value), so as long as the futures markets have a premium, then this opportunity is available consistently.
- It is therefore plausible, with a $100,000 pot of starting capital, to earn solid income of $1,000 per week exploiting these arbitrage opportunities if you can spot 1% deviations in the days leading up to settlement on Fridays.