Market efficiency doesn’t come from the magic all-knowing Omega, it comes from a lot of traders looking for inefficiencies, exploiting them and thus closing them. Broadly speaking, there are 2 ways to do it: manually and algorithmically.
Manual trading is slow. A person has to find some information, reason about it and make the trade. This happens at the days/weeks/months scale, so for some non-negligible time the opportunity persist. If you have the proper mindset that allows noticing inefficiencies like those in the examples and you happen to notice them first, you can exploit them.
Only algorithmic trading allows to react instantaneously and remove inefficiencies beyond millisecond scale. However, it is not flexible. You need a big upfront investment in time and money to notice the inefficiency, develop and backtest your strategy, etc. This only makes sense for regular, systematic inefficiencies. AHT and HTZ examples just cannot be handled by algo trading.
Equivalent asset arbitrage (and stat arb) is a perfect fit for algo trading. However, we still sometimes see huge inefficiencies there. How could it happen? The arbitragers have risk limits and these risk limits can get overwhelmed by market dynamics. Suppose there are 2 assets A and B that are either formally the same (as in the Wei Dai’s example) or are almost the same (e.g. BTC swap and spot prices). There are professional arbitragers with some total cumulative capital. When the spread diverges, they bet on the convergence and by doing so make it converge. Normally, everything is ok and the spread is minimal and almost unexploitable. However, under extreme market conditions (e.g. LTCM or Bitmex BTC Swap price liquidations cascade in March 2020) the professional arbitrageurs run out of capital and spread diverges greatly. They know that it will eventually converge, but they have no free capital anymore. This is an excellent opportunity for non-professionals to bet manually on the spread convergence and earn a lot of money with moderate risk.
Sometimes, obvious moderate inefficiencies persists for a long time even under normal market conditions. For example, right now, Deribit June BTC futures trade at 10% premium to the spot price (20k vs 19k). You can just buy BTC for your USD, deposit it on Deribit and fully hedge your BTC exposure by selling June futures. Hold your position until the spread converges (it usually happens in a few months) or in the worst case till expiry. This trade gives you 20%-60% annualised return. Your risk is only the counterparty risk which is not non-existent, but I would say << 5% annualised.
Why does this future spread opportunity persist? I don’t really understand. At the first glance, anybody can take advantage of it. There is nothing fancy here. The asset is very well known. The exchange is rather well known and you can get a slightly worse opportunity on other exchanges like Bitmex. However, when I tried explaining it to my friend who has some investment in stock ETFs he didn’t understand. My hypothesis is that there is just not enough capital in the world understanding such opportunity and being allowed to use it legally and not having even better uses. If it is true, the bar for outperforming “buy and hold stock ETF” is really, really low.
I’m bit confused about the Deribit trade. I can see that you can hedge your position with this trade, but I don’t understand how you get the return?
The futures price will converge to the spot price as expiration draws near, but this is not necessarily the spot price you paid… I must be missing something… Any pointer?
The basic idea is this. Let’s say you buy a bitcoin at 23k USD and sell the BTC futures contract for 25k. At expiration date (or sooner) you will get 25k but will have to handover the bitcoin you paid 23k for. No matter the spot price at that point you will still have made 2k (minus fees). If bitcoin has gone up to 30k you are giving away an asset worth 30 in return for 25k, but you still made a profit since you bought it for 23k. But be aware that the high bitcoin volatiliy can eat your margin account.
Market efficiency doesn’t come from the magic all-knowing Omega, it comes from a lot of traders looking for inefficiencies, exploiting them and thus closing them. Broadly speaking, there are 2 ways to do it: manually and algorithmically.
Manual trading is slow. A person has to find some information, reason about it and make the trade. This happens at the days/weeks/months scale, so for some non-negligible time the opportunity persist. If you have the proper mindset that allows noticing inefficiencies like those in the examples and you happen to notice them first, you can exploit them.
Only algorithmic trading allows to react instantaneously and remove inefficiencies beyond millisecond scale. However, it is not flexible. You need a big upfront investment in time and money to notice the inefficiency, develop and backtest your strategy, etc. This only makes sense for regular, systematic inefficiencies. AHT and HTZ examples just cannot be handled by algo trading.
Equivalent asset arbitrage (and stat arb) is a perfect fit for algo trading. However, we still sometimes see huge inefficiencies there. How could it happen? The arbitragers have risk limits and these risk limits can get overwhelmed by market dynamics. Suppose there are 2 assets A and B that are either formally the same (as in the Wei Dai’s example) or are almost the same (e.g. BTC swap and spot prices). There are professional arbitragers with some total cumulative capital. When the spread diverges, they bet on the convergence and by doing so make it converge. Normally, everything is ok and the spread is minimal and almost unexploitable. However, under extreme market conditions (e.g. LTCM or Bitmex BTC Swap price liquidations cascade in March 2020) the professional arbitrageurs run out of capital and spread diverges greatly. They know that it will eventually converge, but they have no free capital anymore. This is an excellent opportunity for non-professionals to bet manually on the spread convergence and earn a lot of money with moderate risk.
Sometimes, obvious moderate inefficiencies persists for a long time even under normal market conditions. For example, right now, Deribit June BTC futures trade at 10% premium to the spot price (20k vs 19k). You can just buy BTC for your USD, deposit it on Deribit and fully hedge your BTC exposure by selling June futures. Hold your position until the spread converges (it usually happens in a few months) or in the worst case till expiry. This trade gives you 20%-60% annualised return. Your risk is only the counterparty risk which is not non-existent, but I would say << 5% annualised.
Why does this future spread opportunity persist? I don’t really understand. At the first glance, anybody can take advantage of it. There is nothing fancy here. The asset is very well known. The exchange is rather well known and you can get a slightly worse opportunity on other exchanges like Bitmex. However, when I tried explaining it to my friend who has some investment in stock ETFs he didn’t understand. My hypothesis is that there is just not enough capital in the world understanding such opportunity and being allowed to use it legally and not having even better uses. If it is true, the bar for outperforming “buy and hold stock ETF” is really, really low.
I’m bit confused about the Deribit trade. I can see that you can hedge your position with this trade, but I don’t understand how you get the return?
The futures price will converge to the spot price as expiration draws near, but this is not necessarily the spot price you paid… I must be missing something… Any pointer?
The basic idea is this. Let’s say you buy a bitcoin at 23k USD and sell the BTC futures contract for 25k. At expiration date (or sooner) you will get 25k but will have to handover the bitcoin you paid 23k for. No matter the spot price at that point you will still have made 2k (minus fees). If bitcoin has gone up to 30k you are giving away an asset worth 30 in return for 25k, but you still made a profit since you bought it for 23k. But be aware that the high bitcoin volatiliy can eat your margin account.