Hedge Funds Are Doing The Bitcoin Basis Trade, And You Can Too

• Hedge funds are using the bitcoin basis trade to capitalize on the price difference between futures and spot prices (a.k.a., the basis spread).

• The basis spread has been narrowing – which suggests the trade is becoming overcrowded. This could lead to hedge funds closing their short positions, potentially triggering a short squeeze.

• You could place a directional bet anticipating a move higher or lower for bitcoin, or a non-directional bet that replicates the basis trade by buying spot bitcoin and shorting CME Micro Bitcoin futures. Just be aware of the risks.

Bitcoin may be in a summer lull, but that hasn’t stopped some hedge funds from making good money on it. They’re shorting (betting against) bitcoin futures contracts while simultaneously buying spot bitcoin through ETFs or crypto exchanges. It’s called the bitcoin basis trade. Here’s what they’re doing, what it could mean for the market, and how you might get in on the action yourself.

What are these hedge funds doing exactly?

Bitcoin spot ETFs have been trading in the US since January, raking in capital from investors. In fact, the wallets of those ETFs together now hold over 873,000 bitcoins, according to data from crypto research firm The Block. That’s more than 4% of the total bitcoin supply – and over $50 billion in value.

But as those ETF flows poured in, hedge funds (dark blue line) have sold short a record number of bitcoin futures contracts on the Chicago Mercantile Exchange (CME). Those short futures contracts are just what they sound like – agreements to sell the crypto for a set price on a future date.

Now, you might assume these funds are going short because they’re betting on bitcoin’s fall. But a decent chunk of that open interest is likely for “market neutral” strategies. In other words, hedge funds aren’t necessarily betting that bitcoin’s price will come down. Instead, they’re doing the bitcoin basis trade to earn profits from the “basis spread” – that’s the difference between the futures price and the spot price.

Let me explain how that works. See, the futures price of bitcoin often trades above the spot price (in what’s known as “contango”), and that prompts hedge funds to swoop in and take advantage. They short bitcoin futures contracts on the CME (at the higher futures price) and simultaneously buy an equal value of bitcoin in the spot market (at the lower spot price). As the futures contracts get closer to their expiration dates, the gap between futures and spot prices typically narrows. Hedge funds then close their positions by buying back the futures contracts and selling their spot bitcoin – banking the initial price gap (or basis spread), minus any trading and borrowing costs.

If hedge funds get in at the right time, the basis spread (blue) can earn them a tidy sum. The futures price is often more than 1% higher than the spot price – but when things get volatile, it can be more like 4% higher. And as you can see from this next chart, those basis spikes don’t last long. Hedge funds jump in quickly to capitalize and can close their positions within just a few days to book those profits.

What could the basis trade mean for bitcoin’s price?

That’s where things get interesting. As that chart shows, the basis has squeezed into a tighter trading range (yellow) since March. And during that time, bitcoin’s weekly Bollinger Bands – which track the crypto’s week-to-week volatility – have also squeezed together (next chart). If you’ve read our Bollinger Bands guide, you know what that means: bitcoin’s in the calm before the storm. The OG crypto is getting closer to a big, volatile move, as the Bollinger Bands eventually expand from an ultra-narrow base.

As for the direction of that move – that’s obviously harder to predict. But here’s one potential scenario: as more hedge funds jump on the basis trade, it gets overcrowded, and the basis spread gets competed away. The basis trade then gets less profitable for hedge funds – meaning, they might look to close their short positions. And they’d need to buy back bitcoin futures contracts to do that. That could trigger a potential “short squeeze” scenario in the futures market, which could drive bitcoin’s price higher.

Now, you might be thinking: that’s great news. But just be aware that this could happen in the opposite direction too: this volatile move could end up being to the downside.

What’s the opportunity here?

There are three potential ways to play this.

Behind door number one is a basic directional bet on bitcoin. In other words, you could simply buy bitcoin in anticipation that its price will go up because of a short squeeze. That’s easy enough to do through a wallet app, brokerage, centralized exchange, or bitcoin spot ETF.

Behind door number two is a non-directional play. And in this case, you’d be replicating the basis trade yourself. Here’s how:

• First, find a platform to buy spot bitcoin. You can use ETFs through your broker or regular bitcoin through a crypto exchange like Coinbase.

• Next, find a broker that lets you short bitcoin futures contracts. Opt for CME Micro Bitcoin futures contracts – these are smaller in size compared to the standard contracts that hedge funds use. Check out our

  Micro Bitcoin futures guide

  for the lowdown on that.

• Finally, wait patiently for the right time to enter the basis trade – then buy spot bitcoin and short an equal value of the futures contract with the closest expiration date. Remember, the basis spread is narrow right now as the trade is overcrowded. But the basis spread could widen significantly if and when bitcoin’s volatility returns (especially if there’s a short squeeze). And that’s your time to shine.

Behind door number three is a more bearish plan. You could take a directional short bet by selling CME Micro Bitcoin futures without buying the spot. Just make sure to use a stop-loss if you do – many a trader has been burned trying to short bitcoin without one.