In a recent article by Binance Research, we explored the possibilities of constructing a synthetic trading pair with the use of perpetual swap contracts on Binance Futures. In this article, we continue to explore the applications of synthetic trading pairs by developing trading strategies that offer a unique way of generating alpha across crypto markets. In traditional finance, it is a popular strategy among professional traders and it offers uncorrelated returns to the general market. This strategy is known as market-neutral trading.
What is market-neutral trading?
A market-neutral trade involves opening long and short positions simultaneously to take advantage of inefficient pricing between crypto-assets. Profit is determined from the relative price change between two assets instead of the direction each moves.
For instance, if a trader believes Bitcoin is overvalued and Litecoin is undervalued, he or she would open a long position in Litecoin and simultaneously open a short position in Bitcoin. In other words, it is a non-directional trading strategy where traders can generate profits regardless of bull or bear markets.
Market-neutral strategies are excellent for the highly-volatile crypto markets, especially in recent times. However, market-neutral trading strategies are not risk-free, unlike traditional arbitrage. That said, the strategy does offer many benefits that help a trader to maximize profits without necessarily increasing exposure to risk.
How does it benefit traders?
Market neutral trading offers several benefits to trader portfolios, including diversification from directional strategies, the ability to reduce the volatility of a portfolio, and cushion against a market decline.
Diversification - To manage risk efficiently, traders combine strategies to diversify their returns over time. With this approach, the long-term returns of a portfolio are not tied to the performance of just one or a few trading strategies. Additionally, market-neutral strategies also produced low levels of correlation to the broader crypto markets.
Volatility dampening - Market neutral trading appeals to traders as the strategy delivers lower volatility than conventional strategies. Typically, market-neutral returns are expected to be independent of the broader market. As such, a spike in market-level volatility may not have an impact on the strategy.
Risk mitigation - Another benefit that the strategy offers is a way for traders to mitigate severe losses during market sell-off. These strategies typically have a beta-neutral exposure to the market; sharp market movements should not influence the performance of the strategy. In contrast, traditional strategies typically have high levels of market exposure and tend to correlate with the broader market. Except for pure short-selling strategies, market-neutral strategies historically have the lowest positive correlations to the market.
A great advantage of market-neutral strategies is their emphasis on constructing portfolios to mitigate market risk. In volatile markets, historical results have shown that market-neutral strategies are likely to outperform other strategies.
Types of market-neutral strategies
In traditional finance, there are many variations of market-neutral strategies. In the following examples, we shall focus on a sub-set of market-neutral strategies, specifically mean-reversion strategies that are applicable across crypto markets.
These mean-reversion strategies are basis trading and statistical arbitrage.
1. Basis Trade (Futures and Perpetual swaps)
Basis trading typically consists of a long position in the underlying crypto-asset and a short position in its derivative (in most cases, this refers to cryptocurrency futures or perpetual swaps).
Basis trading exploits the price-differential of two markets and is commonly known as ‘cash and carry’. Traditionally, basis trades consist of open positions in the spot market and a futures contract.
Typically, futures contracts are priced higher than the underlying spot markets. However, it is not uncommon for futures contracts to trade lower than the spot market. Thus, the basis can be positive or negative.
Example of Basis trade (Spot vs Futures contract)
Chart 1 - Historical prices of BTCUSDT (in Blue) on Binance vs CME’s Bitcoin Futures March 2020 (in Orange).
Constructing a basis trade with a futures contract:
Buy 5 BTC at $8,000 each with USDT on Binance.com
Open a short position of 1 contract in Bitcoin March 2020 Futures
Close futures position as price converge with spot markets
Basis trades can be performed with Perpetual Swaps as well. Unlike conventional futures, perpetual contracts do not settle in a traditional sense and have no expiry. For instance, a trader can keep a short position to perpetuity unless he gets liquidated.
Furthermore, perpetual swaps are designed to be closely priced to spot. Thus, crypto-exchanges created a mechanism known as Funding Rate to ensure that contract prices correspond to the index.
Funding rates are periodic payments either to traders that are long or short based on the difference between perpetual contract and spot prices. Therefore, depending on open positions, traders will either pay or receive funding.
Chart 2 - Historical funding rates across exchanges
In different market conditions, the funding rate fluctuates and is re-calculated every 8 hours. At times, funding rates may offer a high premium or deep discount to spot index as market sentiment changes. As this happens, it offers an opportunity for traders to bet on funding rates to revert to its mean.
As shown in Chart 2, historical funding rates across exchanges tend to remain low. However, funding rates may fluctuate. In certain cases, funding rates may spike to extreme levels (as shown in early February). In these situations, a trader can exploit the inefficiency by taking a position in both spot and perpetual swaps market.
Example of Basis trade (Spot vs Perpetual swaps)
When funding rate spikes above 2 standard deviations from its mean:
Buy 5 BTC at $8,000 each with USDT on Binance.com
Short 5 contracts of BTCUSDT perpetual swaps on Binance Futures
Buyback perpetual contract as funding rate reverts to its mean.
2. Statistical Arbitrage
Statistical arbitrage employs quantitative methods to uncover price discrepancies between two or more crypto-assets. Based on these quantitative findings, traders bet on prices of the selected crypto-assets to mean revert by opening long and short positions simultaneously.
To construct a position, traders select crypto-assets that display a strong positive price relationship using statistical methods such as correlation and cointegration.
Correlation - a statistic that measures the degree to which two securities move in relation to each other. Correlations are widely used in traditional finance and advanced portfolio management. Correlation values range between -1.0 and +1.0. The historical prices of two securities that generate a correlation measure of 1 indicate that the two securities have a strong price relationship.
Table 1 - 30-day correlations across large-cap cryptocurrencies
For an interpretation of correlations at the fundamental level, please visit Binance Research’s report about annual correlations.
Cointegration - a mathematical model that studies two or more sets of random time series that are likely to display a mean-reverting relationship. The cointegration test identifies crypto assets that may behave independently in the short-term, but are unlikely to deviate from its equilibrium in the long term.
Based on these criteria, we have identified EOSUSDT and TRXUSDT perpetual contracts as both have displayed a sufficient level of mean-reverting behavior.
Chart 3 - Historical prices of EOSUSDT (in blue) and TRXUSDT (in yellow)
Traders can execute this strategy on our Binance Futures platform under the following scenario:
Short TRXUSDT and Long EOSUSDT
To exit position, buy TRXUSDT and sell EOSUSDT
In cases where the reverse scenario happens, traders can simply go short EOSUSDT and go long on TRXUSDT.
Risks in Market Neutral Trading
Although a market-neutral strategy offers unique benefits such as diversification and portfolio volatility reduction, it is not risk-free. There are several risks and drawbacks traders need to consider before deploying this strategy.
1. Execution risk - In volatile market periods, executing two-legged spreads can be a challenge. In these periods, price movements can be sharp and fast-changing which may lead to slippages.
2. Correlation/Cointegration failure - It is important to be updated with changes in correlations as fundamental factors may impact individual price movements of crypto-assets. As this happens, a pair trade could quickly turn sour as assets move in different directions than expected. In general, past behaviors are not necessarily bound to repeat.
3. Price Filling - Profiting in pairs-trade or arbitrage often relies on razor-thin margins, hence there is a significant risk that orders will not be filled at the desired price when opening or closing positions in a pairs-trade. In particular, pairs-trade in markets where liquidity is low, which often occurs on small-cap altcoins.
Market-neutral strategies may be a valuable alternative to a traditional long-only portfolio. A well-designed market-neutral strategy can provide excess returns regardless of the swings in the broader crypto markets. Therefore, it should help to shield traders from market crises and periods of unnerving volatility.
These advantages may be particularly important to traders now, given that markets remain uncertain. While market-neutral trading can mitigate risk and allow traders to profit in any market conditions, it requires active management as traders must be updated with market developments to ensure that risk is mitigated.