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Don't look at market pullbacks through the eyes of old-school traders



In recent days, in addition to the sharp drop in the price of Bitcoin, there is another thing that has also attracted the attention of cryptocurrency investors and traders-CME Group's Bitcoin futures have fallen into a state of "backwardation".

Spot backwardation is also known as reverse market or reverse market (Inverted Market), popularly known as spot premium or futures discount, which means that under special circumstances, the spot price is higher than the futures price (or the price of the contract in the recent month is higher than that in the forward month contract price), the basis is a positive value. A widening spread in an inverse market can result in a profit for a bull spread and a loss for a bear spread. In the reverse market, as time goes by, the spot price and the futures price will gradually converge to the delivery month just like in the forward market. Since the demand is far greater than the supply, the spot price is higher than the futures loan price, and when the contract price rises more than the forward contract price, you can enter the market and do bull market arbitrage. But the profit potential of contrarian bull arbitrage is huge and the risk is limited. In addition, no matter in the forward market or the reverse market, the practice of bear market arbitrage is to sell contracts and buy forward contracts at the same time.

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"Backwardation" is a structure of near high and far low, which is destocking. If the near-end price is very high, when it reaches a certain level, the demand will be activated. Traders can borrow other people's inventory and sell it at the near-end, and lock in the far-end price at the same time, because the price is lower and the locked-in The price at the far end is replenished and returned to the warehouse, which also constitutes a risk-free arbitrage of destocking, so the price structure of "spot premium" can also restrain demand.

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The backwardation of bitcoin futures seems to have started at the end of last week, and then continued until this Tuesday (May 18). , traditional market analysis methods may not be applicable to Bitcoin.

Nathan Cox, chief investment officer of Two Prime Digital Assets, said that the "spot backwardation" of Bitcoin does not necessarily mean that the supply situation will be tighter. In fact, it often happens, for example, compared to the Bitcoin futures contract in June, the price of the May contract is slightly discounted (this situation is called contango, that is, futures contango, or contango/discount).

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"Contango" is a downward-sloping futures curve in which near-term contracts are more expensive than forward-dated contracts. For example, from the data source provided by TradingView, it can be seen that the futures contract price of Bitcoin expiring in May 2021 is at a premium of $15 to the price of the futures contract expiring in June, while the futures contract expiring in June 2021 is at a premium of $15. The price was another $55 premium over the futures contract expiring in July.

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As defined by the investment encyclopedia website Investopedia, higher demand for an asset relative to contracts that expire in the futures market in the next few months will lead to an increase in reserves. However, this definition seems to be more suitable for a traditional market like oil. In the oil market, demand is related to economic growth to a certain extent (can be calculated by a function), and the oil market will change due to various uncertainties, sometimes reducing production. , Sometimes there is a sudden surge in economic activity, which in turn leads to tight supply conditions in the market.

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Market analysts also sometimes attribute the "contango" situation to the cost of storing commodities for longer periods of time.

One point of reference could be the futures market for West Texas Intermediate, the main benchmark for U.S. oil prices. The market nearly went “closed” in November 2020 due to continued production cuts by the Organization of the Petroleum Exporting Countries, fully reflecting the shortage of supply in the market at the time. Starting in November 2021, however, WTI started rising from $44 before reaching $68 in March 2021, its highest level in recent months.

Nathan Cox explained:

“Oil spot and futures markets have very different inputs into the calculations, and oil demand can be quantified more explicitly than digital assets, which in turn suggests a greater correlation between pure price expectations and actual use or demand.”

It is worth mentioning that West Texas Intermediate crude oil futures listed on the New York Mercantile Exchange (NYMEX) are physically settled.

Reuters pointed out last year that when the West Texas Intermediate crude oil futures contract expired, only some of the "paper" oil was converted into physical barrels of oil that needed to be used, or stored in major U.S. storage locations. physical barrels of oil. However, the bitcoin futures listed on the Chicago Mercantile Exchange (CME) are cash-settled, which means that CME Group is issuing a contract with a lending nature, so there will definitely be profits and losses in the trading account. In other words, buyers of CME Bitcoin futures do not receive delivery of physical Bitcoin, so the CME Bitcoin futures contract is more of a speculative vehicle.

Jarvis Labs crypto economist Ben Lilly said in a Telegram chat:

“The main difference between bitcoin and oil futures is speculative, and we find that backwardation tends to be a better predictor of reversals or buying opportunities, especially in bull markets.”

So far, the bullish sentiment conveyed by the alleged recent discounting of Bitcoin futures has failed to translate into higher prices. According to Coingecko data, as of this writing (May 23), Bitcoin’s trading price has fallen to $36,586.53, a 7-day drop of up to 21.8%.

Nathan Cox, chief investment officer at Two Prime Digital Assets, continued:

“This shows that Bitcoin’s future price expectations are actually lower than the spot price.”

According to Rahul Rai, managing partner at Gamma Point, spot appreciation can hardly be considered a bullish sign, as Bitcoin futures are where institutional investors gain large-scale exposure to Bitcoin — all things considered, the situation It may represent a certain degree of bearish sentiment among institutional investors.

Rahul Rai added that Bitcoin futures discounts are not the result of a real-time supply squeeze, but are driven by institutional arbitrage liquidity. Profit from the difference between the price and the spot market price.

The CME Group is the main venue for institutions to execute basic arbitrage transactions to short futures. Therefore, there is continuous selling pressure on the funds for arbitrage transactions. The cash arbitrage strategy involves selling futures contracts against long positions in the spot market. That is, institutional investors can earn fixed income as the contango decays over time and converges with the spot price at maturity. Position traders often execute short futures contracts in liquidation trades that are months away, and they offer a premium that is higher than the premium on the contract, which means that in the process, they must want to keep moving contracts that are months away. Premiums pushed lower.

Another factor that makes CME Group futures vulnerable to spot prices is low retail investor participation, and despite larger lot sizes, CME Group does not offer as many leveraged futures contracts as other competitors, such as cryptocurrency. Ann (Binance), but it should be noted that most cryptocurrency exchanges are not effectively regulated.

Rahul Rai finally explained:

“Since the minimum trade size for CME Bitcoin futures is 5 contracts, or 5 BTC (they just recently launched micro Bitcoin futures), and retail leverage is usually bid on spot exchanges and expands the trading base, it is mainly concentrated in Retail investors don't choose CME Group when it comes to centralized cryptocurrency exchanges."

Author | Omkar Godbole Translator | Moni


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