This is the second article of the three-part series in which I describe arbitrage techniques on cryptocurrency futures and BitSpreader as a tool for executing the arbitrage trades on cryptocurrency futures. You can find the first part in which I introduce arbitrage and give concrete examples of arbitrage trade HERE. In this article I use data from the example from the first part.

This article describes the details of the execution, the risks and the analysis of returns. Third part of the series describes the most advanced execution technique called auto-spreading with use of limit orders.

In the first part I have analyzed the opportunity of performing the arbitrage trade across two exchanges — Derbit and Binance on the futures contracts with delivery date on 31st March 2023. The expected gross profit in the considered situation was 42,5 USD with the position size of 1 Bitcoin on each side. Is this a good profit? You can’t say that before taking under account couple of factors:

• What are the transaction costs — in other words what is the net profit — it my turn out that the exchange will charge us the fees that will exceed the gross profit
• What is the amount of funds we need to engage to produce the target profit — in other words what is the return on investment
• What are the risks of the transaction?

To answer these questions we need to dig into following aspects:

• What is the leverage that we use — the higher leverage, the bigger ROI, but also the bigger risks
• What is our execution method — in case we execute the arbitrage trade with the use of market orders, the transaction costs will be higher than in case we execute it with the limit orders. The execution method also impacts another factor that we need to consider — the latency and the potential slippage.

Exposure on Bitcoin price

First thing worth discussing is what is our exposure to the Bitcoin price — this is a major benefit of the arbitrage trade — this exposure is very limited (except for the risk of liquidation that is discussed in the next paragraph). In case the BTC price goes up, one of the two legs of our spread trade — the long leg — generates the profit — let’s call it the “winning leg” and the other — the short leg generates the losses. The profit from the “winning leg” compensates for the losses of the “losing leg”. Similarly in case the BTC price goes down, our short leg becomes the “winning leg” and generates the profits that compensate of the losses generated by the “losing leg” — in this case the long leg.

Leverage and margin

All exchanges that provide futures trading on cryptocurrencies allow to trade with the leverage. Leverage allows you to control a position larger than the value of the assets in your account. Leverage is the ratio between a trader’s position size and the equity used as collateral for the position. Depending on exchange, allowed leverages are in range between 1x and 50x. Margin is the funds in your account used as collateral for your positions. We distinguish between initial and maintenance margin. Initial margin defines the assets required to be available on the account in order to open the position. The initial margin is calculated as the position size divided by the leverage. For example if you want to trade with the value of 1 Bitcoin with the leverage 10x, you only need 0.1 BTC of margin on your account and with leverage 50x it is 0.02 Bitcoin. Usually the maintenance margin is 50% of initial margin, if our margin falls below maintenance margin, the exchange liquidates our position to limit our losses. Exchanges provide two options regarding the margin: “cross-margin” and “isolated margin”. Cross-margin means that your whole account balance is used as a margin for our open positions. In case of isolated-margin you set a dedicated margin just for a single position. For the sake of futures spread trading and the arbitrage cross-margin is very convenient in case we perform both legs of our spread trade on one exchange. That is because all the profits on the “winning leg” are considered to be the assets working as the margin for your “losing leg”. That means, as long as we have both positions open, we will not be liquidated. As in this article we are talking about the cross-exchange arbitrage, we do not have this comfort — our losing leg may be the subject for the liquidation. The higher leverage we use, the higher the chance that our position will be liquidated. Please checkout very good article on Deribit Insights with introduction to leverage and margin and the diagram:

In case we use the 50x leverage, in case we only have assets equal to our initial margin on our account and the price moves by 2% against our position, the position will be liquidated.

The amount of funds we use as the margin determines the profitability of the whole operation — the less funds we use, the higher return on investment, but that implies the higher liquidation risk. The more funds we have on our account as our margin, the lower return on investment, but also the lower chance of being liquidated.

What happens if one of our legs gets liquidated?

We become exposed to the price movements of the underlying asset. It is our “losing leg” that will get liquidated first. There is no guarantee that the price “shake” on the “losing leg” asset is reflected by the symmetric price move on the “winning leg”. We can hope that if we realize the fact of liquidation ”quickly” and we close our “winning leg” that should compensate for our losses on the liquidated leg.

Fees using market orders

Let’s consider executing the arbitrage trade from the example in Part 1 with the Auto-Trigger order.BitSpreader executes auto-trigger order when the spread price reaches the trigger price provided by the user. For BUY orders, BitSpreader executes the order when the spread ASK price goes below the triggerprice, for SELL orders, BitSpreader executes the order when the spread BID price goes above the trigger price. When triggered, BitSpreader executes two market orders simultaneously. Buying the spread means executing two market orders, selling the spread means two more market orders. For each market order we pay the taker fee. In the basic level fee tier Binance has 0.04% taker fee and Deribit has 0.05% taker fee. For all the trades together we would pay 0.18% fee. As the prices analyzed earlier refers to 1 Bitcoin, 1 Bitcoin is around 20300 Dollar, 0.18% is 36,5 dollars. After subtracting this from our profit — that is 42.5 dollars we are still at a profit of 6 dollars.

The question is — will the auto-trigger be able to catch these spikes in price? The spikes in price that we have observed may be very short lasting. In order to execute the AutoTrigger order BitSpreader first needs to receive the message from the exchange about current levels in the order books, it needs to compute the difference and in case the triggering condition is met, call the exchanges again to issue two market orders. There is a latency involved that can cause the slippage.

Slippage

As the order books may change between the moment when BitSpreader observed the triggering condition and the moment of market order execution, we may encounter the SLIPPAGE. Actual price for which we buy the spread may be different from the triggering price. The risk of the slippage grows if we want to catch very short bursts of price with the Auto-Trigger orders. We may sometimes even end up with the loss as the fees for the trades exceed the profit.

Alternative approach — AutoSpreading with limit orders

As an alternative scenario let’s consider executing this arbitrage trade with the AutoSpreading order.BitSpreader executes AutoSpreading orders with use of one market order and one limit order. First we choose on which market BitSpreader will be placing the limit orders — the quoting market and on which BitSpreader will be placing market orders — the hedging market. BitSpreader puts a limit order on the quoting market with the price that is computed as the price on the hedging market + provided spread price. Every time the hedging price moves, BitSpreader updates the limit order. When the limit order is filled, BitSpreader instantly hedges by executing opposite market order on the hedging Market.

This approach is much faster — on one side of the spread trade we use the exchange mechanism to match our limit order, the probability of the high slippage is significantly reduced however the slippage is still possible. Also the fees are much lower.

On Deribit the maker fee for limit orders is 0%, on Binance in the basic fee tier it is 2 basis points, in total the fees for the spread trade made with the use of AutoSpreading orders will be 11 basis points that is 22.3 dollars. That gives us the net profit 22.2 dollars. And also reduces the risk as we are less exposed for the latency issues in the AutoSpreading mode. The third article in this series will describe in details the AutoSpreading.

Return on investment

To understand what is the return on investment we need to divide the funds used to generate the profit by the net profit. In case we use the leverage 50x we have to guarantee 0.02 BTC on each side, 0.04 BTC total, what with the Bitcoin price equal to 20300 is 812 USD. In case we decide to use AutoTrigger orders, the net profit of 6 dollars gives us the return on investment equal to 0.7% on a single transaction. In case we use AutoSpreading, the net profit of 22.3 dollars gives us the ROI 2,77% on a single transaction. Not bad. But we also need to consider the risks. As we are using the leverage 50x, if the price moves by 2% during the window in which we have open position and we wait to close it, in this case this is approximately 500 dollars (which is not rare in the world of Bitcoin), one of our legs will get liquidated. In order to mitigate that risk we can increase the margin on the “losing leg” — i.e. double it. In case we do this, the total funds engaged is 1218 dollars, and the ROI is 1,85%, which is still very decent profit, taking into account lack of exposure for the BTC price moves.

I invite you to try out BitSpreader — Cryptocurrency Futures Spread Trading platform that provides traders with the full toolkit necessary to trade with this strategy — first 30 days are for free, with no credit card required.

If you are a spread trader — I’d be grateful for any notes, comments and/or any feature requests that we could implement in BitSpreader to make your trading experience smoother.

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