Futures Hedging: A Comprehensive Guide

1. What is Spot-Futures Arbitrage?

The essence of spot-futures arbitrage lies in capturing the funding rate. The “spot-futures” in spot-futures arbitrage refers to perpetual spot-futures transactions, implying two simultaneous transactions of opposite directions, equal quantities, and offsetting profits and losses in spot and perpetual contracts, to earn the funding fee from the perpetual contract transactions. Spot-futures arbitrage is a trading strategy to hedge price risk, meaning that price changes will not affect returns. It is a relatively low-risk strategy.

1.1 What is a Funding Fee?

The funding fee is a settlement mechanism in perpetual contracts. Since perpetual contracts have no delivery, other mechanisms are used to stabilize the spot-futures spread, and this mechanism is the funding fee. In simple terms, the funding fee is the cost that the contract’s long side pays to the short side to balance the sentiment between the bulls and bears.

Calculation of Funding Fee:

Funding Fee = Position Value * Funding Rate

About the Funding Rate:

The principle of the funding rate mechanism is that when one side of the perpetual contract’s participants and capital is excessive, a certain funding interest rate must be paid to the counterparty to stimulate the increase in the number of participants and investment in the counterparty’s side. Generally, the stronger side among the bulls and bears pays the weaker side. Currently, in most market scenarios, the long side pays the funding fee to the short side, and the percentage of funds paid to the short side is the funding rate.

The funding rate is determined based on the current bull and bear situation, derived from the exchange’s algorithm, and each exchange has a different algorithm. Here are the details of Gate.io’s funding rate:

https://www.gate.io/fee

https://www.gate.io/help/futures/futures_logic/27569

2. How to Arbitrage?

The Gate.io platform supports spot-futures arbitrage under the scenario where the long side pays fees to the short side, which is also the market’s most stable and common scenario.

By shorting (perpetual) contracts (1X) while holding an equivalent value in spot assets, the contracts and spot assets can balance and hedge each other while earning the funding rate every eight hours. The funding rate rules on Gate.io are: the funding rate is calculated every minute, and the average value over a period (8 hours) is taken as the final funding rate. The current funding rate is applied at each funding rate period (8 hours). The funding fee is settled three times a day, at UTC 0:00, 8:00, and 16:00, with the position value based on these timestamps.

3. Factors Affecting Arbitrage Returns

Based on the formula for arbitrage returns: Arbitrage Returns = Funding Fee (Position Value x Funding Rate) - Spot Trading Fee - Contract Trading Fee. Also, the funding rate is influenced by the spot contract premium index. Therefore, the final factors affecting arbitrage returns include the funding rate, transaction rate, and spot-futures premium index.

Funding Rate

Therefore, the higher the funding rate, the higher the arbitrage returns under the same position conditions.

Transaction Rate (Contract and Spot)

In addition to the funding rate, users are charged a transaction fee for every additional spot long or contract short they make. Different cryptocurrencies have different transaction fees. According to the formula for arbitrage returns, the user’s trading currency and the number of trades will result in a corresponding transaction rate, which will ultimately affect arbitrage profits. For details on the transaction fees for each cryptocurrency on Gate.io, please refer to: https://www.gate.io/fee

Price Difference Between Contracts and Spot

Since the calculation of the funding rate mainly considers the interest rate difference between the pricing currency and the settlement currency, as well as the price difference between the internal transaction price and the external spot price (i.e., the premium index), the price difference between the contract and the spot will affect the calculation result of the funding rate, thereby affecting the final arbitrage returns, i.e., the funding fee.

4. How to Choose Cryptocurrencies for Spot-Futures Arbitrage

Positive funding rate, the higher the better

As per the funding fee = Position Value * Funding Rate, the higher the funding rate, the higher the final funding fee (arbitrage return).

Very small price difference between contracts and spot

Choose cryptocurrencies with a small price difference between contracts and spot. When opening a position, you can choose a combination of futures and spots with a slight price difference. This can control the investment cost, and when a price watershed appears between contracts and spots later, you can reap the funding fee (arbitrage return) resulting from the large basis difference between futures and spots.

Cryptocurrencies with low transaction rates

Because users are charged a transaction fee every time they go long on the spot or short on a contract, the arbitrage return for users will be influenced by the trading currency and the number of trades. Therefore, the lower the transaction rate, the more profits users can keep.

5. Spot-Futures Arbitrage Case Study

Take BTC spot and perpetual contracts as examples of how spot-futures arbitrage works. If the market funding rate is 0.1% and remains unchanged, arbitrageurs will buy spot and short perpetual contracts. Assuming that the current BTC price is 5000 USDT, an investor carries out spot-futures arbitrage with an investment of 10,000 USDT, running the strategy for 365 days.

Firstly, the total funds (10,000 USDT) are divided into two parts. One BTC is purchased (for 5000 USDT), and then one BTC is shorted on the perpetual contract market with 5000 USDT (without leverage).

Secondly, after shorting the perpetual contract, the short-seller receives a funding fee every 8 hours, amounting to 5 USDT.
(1_5000_0.1%=5USDT)

Thirdly, during the operation of this strategy, the investor can generate a return 1095 times (365_3=1095; three times a day). The annualized return rate can reach 16.425% (1642.5/10000_100%).

Users can easily make money using the Spot-Futures arbitrage strategy, not through purchasing spot and contracts themselves, but with the help of Gate.io’s quantitative copy-trading.

6. Guidelines for Spot-Futures Arbitrage Operations

On the web: Navigate to Quantitative Copy Trading > Quantitative Strategy > Create New Strategy > Steady Long-term Investment Profits section > Spot-Futures Arbitrage > Create Strategy > Configure Parameters > Click Create

On the App: Go to Quantitative Copy Trading > Click on Strategy Templates > Select Spot-Futures Arbitrage > Set parameters

Terminology Explanation:

Leverage Multiple: This refers to the leverage multiple when shorting a perpetual contract, which can be set within the range of 1X to 3X.

Current Spot-Futures Spread: This is the actual spot-futures spread in the market, which is variable and serves as reference data for opening and closing orders.

Spot-Futures Spread Control: This refers to the control of the deviation between the final transaction average price of spot and futures contracts and the order price through parameter setting within a certain proportional range. Typically, a page would show the current spot-futures spread difference. Users can set the value for spot-futures spread control based on this figure. The value for spot-futures spread control generally needs to be lower than the current spot-futures spread difference to facilitate smooth position opening. If the spot-futures spread value diverges excessively from the user-input value, it can trigger an automatic position closure. (Due to significant fluctuations in the crypto market, the final transaction price of a contract often differs from the order price when a trader is trading. At this time, the degree of price changes between spot and futures can be controlled through spot-futures spread control.)

7. Explanation of Considerations for Spot-Futures Arbitrage

Although the Spot-Futures arbitrage strategy is known for its low-risk nature, it is not a completely risk-free investment method. In certain extreme circumstances, it may result in losses for investors. The primary risks include:

Changes in the direction of interest rates

While in the majority of cases, the contract market involves the long side paying the short side a funding fee, there are instances where the short side pays the long side. In such cases, you incur interest expenses instead of earning interest income. The good news is that the direction of interest rates on Gate.io is very stable, with changes being rare. Occasional losses caused by changes in interest rates can be compensated in the next funding charge.

Liquidation

The Spot-Futures arbitrage strategy requires the use of perpetual contracts to establish positions, which involves the use of leverage. When the price of a currency experiences a significant change, your position might be liquidated. To reduce this risk, Gate.io limits the use of leverage in Spot-Futures arbitrage strategies. Users can use a maximum of 3x leverage when opening a position.

8. Conclusion

Compared to conventional investments, futures arbitrage often yields more stable returns and lower risks. Its performance is not impacted by price fluctuations. Regardless of market changes, arbitrage can be achieved, ensuring positive returns. While the risk of futures arbitrage is incredibly low, there still exist two scenarios that might lead to principal loss. Overall, it remains a strategy with a high return on investment ratio.