This article is for advanced and discerning traders who are already familiar with the basics of index arbitrage. Additional resources are available in the OKEx Academy if you need further explanations of the concepts of basic, margining and fair value calculation. Today we're going to discuss a trade that would have returned> 10% last month. The idea is very similar to the credit and carry trade discussed Here. To simplify the discussion, we assume that we will build an index arbitrage position on February 12 and then process it at the most favorable time on March 13. However, the centerpiece of the discussion arises from the discussion of how to maximize return on investment and reduce risk by using both OKEx's inverse and linear futures.

**The vanilla trading idea**

The following graphs show the percentage basis on February 12 and March 13, 2020. Each graph contains the percentage basis of both the inverse coin-edge USD futures from OKEx and the linear USDT-margin futures. At a quick glance, we can see how the linear future base is consistently higher than the inverse future base that we will discuss later. This spread between the two quarterly BTC futures is determined by the external lending rate of the underlying and also by how the margining works.

On February 12, the market traded with Contango, near the quarter futures were trading ~ 5% above the spot price, and the trading language we should use is that the futures were traded "richly". A month later, on March 13, the market was trading backwards. Futures close to the quarter were trading at ~ -15%. Both futures were traded “cheaply”. Trading is to buy spot and rich futures on February 12th and then buy back spot and bill futures on March 13th^{ }for a strong return of 20% for a holding period of one month. The idea of this index arbitrage trading is pretty simple, but the devil is in the details.

**Maximize capital consumption and maximize profit**

The timing of the base is impossible, so you don't expect to actually reach that 20%. Since we cannot predict the futures base and do not know exactly when the time to build and process our inventory, let's take a look at other parts of the equation, which futures to use and why. We will now focus on maximizing our return on investment and reducing our risks.

**Nuance 1: If inverse and linear futures have the same positive basis, is it better to use inverse futures to build an index arbitrage position?**

OKEx is the only exchange that offers both inverse and linear futures. The margin of these BTC futures is BTC or USDT. Suppose you have $ 10,000 for arbitrage, which means that you can buy $ 10,000 BTC and sell $ 10,000 BTC futures. Which future should you use? The USDT future actually has a higher base of ~ 0.7 due to its margin requirements. If you opt for inverse futures, you would buy BTC worth $ 10,000 and use it as future security. In essence, you would never be forced to liquidate due to the inverse payout (see example 1).

*# Example 1: (Assuming fee = 0, leverage = 10x)*

*The liquidation price entered on February 13 at 3:00 p.m. is infinite.*

*Suppose we hold the position until it expires and release the spot position and settle the future at the same price (and 1 USDT = 1 USD). Your return is ~ 5%, which is approximately 0.0492 BTC **（**~ $ 513**）**.*

If you have decided to gain more base with the linear USDT futures, you will need to reserve a significant amount of cash and buy USDT to limit the linear future. The base would be higher for each index arbitrage position, but you would have less dollar base for capital consumption. Most importantly, there is a chance that you will be forced to be liquidated if the market shoots up as there are unlimited downside shorting futures.

**Nuance 2: If inverse and linear futures have the same negative basis, is it better to use linear futures to settle the index arbitrage position?**

Conversely, if both inverse and linear futures are traded at a discount to the spot, which futures should you use and why? If you follow the logic above and all other things are the same, you should use the linear future to build an inverted arbitrage position (Sell Spot Buy Future). If you sell spot on the OKEx spot market, you will get USDT back. With this USDT you can achieve a 1: 1 margin on your long future position. Essentially, you will never be forced to liquidate unless the market drops 1 MMR% (see example 2).

*Example 2: (Assuming fee = 0, leverage = 10x)*

*Registered on March 13th at 8:00 a.m., the liquidation price would be ~ 20.*

*If you relax during the March 27 expiry and assume the linear future is $ 4794, your return will be 8.4%, which is approximately $ 840T.*

**Nuance 3: To maximize capital usage and leverage, you can sell a mix of inverse futures and buy linear futures.**

Assuming 1 USDT = 1 USD, nuances 1 and 2 explain why linear futures should consistently have a higher price than inverse futures. If you are low on capital, you can try trading the futures spread. For example, if there is less demand for linear futures than inverse futures on the market, the basis of the inverse future is higher. You can then buy USDT futures and sell inverse futures and capture the spread. Since there is no need to buy or sell spot, you can use it to trade (but be careful with market movements, it can take one leg off) and potentially earn more. OKEx's unique linear USDT futures offer more opportunities for arbitraging.

**Arbitrage: It is never really risk free**

In the academic sense, “arbitrage” means a risk-free chance of winning. This word is used loosely by traders. We'd like to believe that our trades are risk free, but it really isn't. The better traders survived the dark March 13th^{th} fall because they were prepared for high volatility. Leverage is a double-edged sword. A gap up or down can quickly resolve your position before you have the chance to edge again. The main risks for index arbitrage are liquidation, recovery, counterparty and tether exposure.

Binance applied Auto Deleveraging (ADL), a type of force liquidation on a winning position, to its users' positions on March 12th. In a sense, ADL is much worse than liquidation for a trader. First, you never know when ADL will happen to you. Your disadvantage when you are forced to liquidate your short position through ADL means that you lose significantly if the market continues to fall. ADL in a future market makes hedging impossible. At OKEx we do not use ADL for our Bitcoin derivatives.

Since OKEx is a decentralized futures exchange, we instead implement a recovery policy in which profit positions deduct part of their profit and loss account if counterparty positions cannot be forcibly liquidated in time and there are not enough insurance funds to cover the downfall. This is a better alternative than ADL, as the worst case scenario would be that you would only lose part of your income statement while keeping your hedge. Since the revision of our risk machine in 2018, we have had no BTC recoveries in any of our BTC derivatives. The decline on March 12 showed that our sophisticated risk engine is industry leading.

As traders, we can try to lower our compulsory liquidation risk as we know when this will happen. The nuances 1 and 2 showed that the liquidation risk can be reduced by using different futures for long or short exposures. In the worst case, there is still a high probability that you can reopen the same position at a profit if your long hedge position was forced to liquidate due to margin requirements as the market continued to fall.

If you take a position with Tether (USDT), you accidentally expose yourself to a counterparty risk against Tether. For example, if you sell rich linear USDT futures and buy cheap inverse BTC futures, you yearn for USDT and shorting dollars. If USDT releases the pegs and crashes when everyone else is equal, BTC-USDT will skyrocket and you will owe USDT. Conversely, you can consider hedging additional tether exposures by trading a combination of linear and inverse futures from OKEx.

**Conclusion**

OKEx's unique combination of different maturities and types of marginalized futures allows traders to create many types of carry trades. You can arbitrage between different implicit interest rates or between different margin futures. With regard to improving your risk profile, we have shown that there is less margin call risk shorting for inverse futures than for shorting for linear futures (and vice versa). Finally, you can build a position between linear and inverse futures to hedge the tether exposure. Taking into account all types of terms and products, OKEx has the deepest liquidity and the best trading opportunities of all exchanges.

*Disclaimer: This material should not be used as a basis for investment decisions or as a recommendation for the execution of investment transactions. Trading digital assets involves significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved, consider your experience and investment objectives, and seek independent financial advice if necessary.*

About the Author:The author of this article is Thomas Tse, Head Quantitative Strategist at OKEx.

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