Cash and Carry Trading in Crypto: A Comprehensive Guide

Cash and Carry Trading: An Introduction

Imagine you find a store selling apples for $1 each, but you also know someone who has promised to buy those same apples from you in a month for $1.05. If it costs you $0.02 to store each apple for that month, you can buy the apples, store them, and sell them to the buyer for a guaranteed profit of $0.03 per apple. Cash and Carry trading in crypto works in a similar way, exploiting price differences between the spot market (where you buy crypto immediately) and the futures market (where you agree to buy or sell crypto at a future date).

Key Takeaway: Cash and Carry trading is an arbitrage strategy that profits from the price difference between an asset's spot price and its futures price, while remaining market-neutral.

Mechanics of Cash and Carry Trading

At its core, cash and carry trading involves two simultaneous actions:

1. Buying the underlying asset (going long) in the spot market. This means you purchase the asset, like Bitcoin, at its current market price.
2. Short-selling a futures contract for the same asset. This means you agree to sell the asset at a predetermined price at a future date. The futures price is typically higher than the spot price due to factors like storage costs and the time value of money, which is known as contango.

Here's a step-by-step breakdown:

1. Identify a Price Discrepancy: You observe that Bitcoin is trading at $60,000 on a spot exchange, and a three-month Bitcoin futures contract is trading at $62,000. This difference suggests a potential opportunity.
2. Buy Spot Bitcoin: You purchase Bitcoin on a spot exchange at $60,000. You now own the physical asset.
3. Short Sell the Futures Contract: Simultaneously, you sell a three-month Bitcoin futures contract at $62,000. You are now obligated to deliver Bitcoin in three months.
4. Hold and Deliver: You hold the Bitcoin you purchased in the spot market for three months. When the futures contract expires, you deliver the Bitcoin you own to fulfill your obligation. You receive $62,000 for the Bitcoin.
5. Calculate Profit: Your profit is the difference between the futures price ($62,000) and the spot price when you bought the Bitcoin ($60,000), minus any carrying costs (e.g., storage fees, funding rates, or interest). If carrying costs are minimal, your profit is $2,000 per Bitcoin.

Definition: Contango: A situation in a futures market where the futures price is higher than the spot price. This is a common phenomenon in cash and carry trades.

Trading Relevance: Why do Prices Move?

The profitability of cash and carry trades relies on the following:

• Contango: The futures price must be higher than the spot price. The larger the premium, the greater the potential profit. This premium can be influenced by factors like market sentiment, volatility expectations, and the cost of funding.
• Carrying Costs: These are the expenses associated with holding the asset. In crypto, carrying costs mainly include borrowing costs if you're using leverage, funding rates, and potential storage fees for custody.
• Market Efficiency: The strategy works best in relatively efficient markets where price discrepancies are quickly arbitraged away. This can be more challenging in less liquid or highly volatile markets.

How to Trade It

1. Platform Selection: Choose a reputable exchange that offers both spot and futures markets for the crypto asset you want to trade (e.g., Binance, Coinbase, Bybit, etc.).
2. Capital Allocation: Determine the amount of capital you're willing to commit to the trade. Consider margin requirements if using leverage.
3. Identify Opportunities: Monitor the spot and futures prices. Use trading platforms' data feeds to identify contango situations.
4. Execute the Trade: Simultaneously buy the asset in the spot market and short the corresponding futures contract.
5. Manage the Position: Monitor the position to ensure you can fulfill your futures contract obligation. Be mindful of any funding rates or carrying costs.
6. Close the Trade: Upon the expiration of the futures contract, deliver the asset and collect your profit.

Risks of Cash and Carry Trading

While considered relatively low-risk, cash and carry trading is not without its dangers.

1. Funding Rates: Perpetual futures contracts (contracts that do not expire) have funding rates. These are payments made between traders to keep the futures price aligned with the spot price. High funding rates can erode your profits. If you are shorting perpetual futures, you'll need to pay the funding rate if the rate is positive. Conversely, you'll receive the funding rate if the rate is negative.
2. Volatility: Unexpected price swings in the spot market can impact margin requirements and potentially trigger liquidation if you are using leverage. Although the strategy is market-neutral, extreme volatility can lead to margin calls.
3. Liquidity Risk: In less liquid markets, it may be difficult to execute both the spot and futures trades simultaneously at the desired prices. This can lead to slippage and reduced profitability.
4. Counterparty Risk: This is the risk that the exchange or futures counterparty defaults on its obligations. Choose reputable and well-capitalized exchanges to mitigate this risk.
5. Carrying Costs: High borrowing costs, storage fees, or funding rates can significantly reduce your profit margin or even lead to losses.
6. Unexpected Events: Black swan events or regulatory changes can significantly impact the markets, leading to rapid price fluctuations and potential losses.

History and Examples

Cash and carry trading has a long history in traditional markets, particularly in commodities. It's a well-established arbitrage strategy. In the crypto space, the strategy gained popularity as futures markets matured and became more liquid.

• Early Bitcoin Futures: In the early days of Bitcoin futures (e.g., 2017), when market efficiency was lower, the premium between spot and futures prices could be substantial (e.g., 15-30% or more over a few months), presenting lucrative cash and carry opportunities.
• DeFi Lending and Cash and Carry: Traders can use DeFi lending platforms to borrow the underlying asset (e.g., Bitcoin) and then short a futures contract. The interest paid on the loan is a carrying cost to be considered. If the contango is large enough to cover the interest, a profit can still be made.
• Institutional Adoption: As institutional investors have entered the crypto market, cash and carry strategies have become more common, contributing to market efficiency and narrower spreads between spot and futures prices.

Conclusion

Cash and carry trading is a sophisticated but effective arbitrage strategy for crypto traders. By understanding the mechanics, managing the risks, and identifying profitable opportunities, traders can leverage price discrepancies to generate returns. However, it's crucial to approach this strategy with a solid understanding of the market, the risks involved, and the importance of disciplined execution.