Executing the Basis Trade: Step-by-Step Setup and Risk Management

Executing the Basis Trade: Step-by-Step Setup and Risk Management

This post is the second in our series on mastering the crypto basis trade, designed to guide you through the practical execution and risk management of this market-neutral strategy using Delta Adjusted Tokens (DATs) and futures contracts. If you missed Part 1, Understanding the Crypto Basis Trade, I recommend reviewing it first to grasp foundational concepts like the basis, delta neutrality, and the rationale behind going long DATs and short futures.

What Is the Basis Trade Recap?

At its core, the basis trade exploits the price difference (the basis) between the spot price of a cryptocurrency and its corresponding futures contract. The classic approach involves:

• Going long spot/DATs (owning the underlying crypto asset)
• Going short futures (selling futures contracts on the same asset)

The goal is to remain delta-neutral—balanced so price moves of the underlying asset don’t affect the net position—while earning profits from funding rates, basis convergence, or price discrepancies[3].

Step 1: Choosing the Right DATs and Futures Contracts

Selecting DATs

DATs are tokenized representations of the underlying crypto assets, often designed to simplify spot exposure with certain adjustments. When selecting DATs for your basis trade:

• Pick liquid, widely adopted tokens such as BTC or ETH for tighter spreads and easier execution.
• Use DATs from reputable platforms with strong custody and security.
• Ensure the DAT’s price tracks the underlying crypto closely to maintain hedge effectiveness.

Choosing Futures Contracts

You can short futures on:

• Centralized crypto-native exchanges (e.g., Binance Futures, Bybit), offering perpetual and quarterly contracts.
• Traditional financial exchanges like the CME, offering regulated futures contracts on BTC and ETH.

Key factors in choosing futures:

Perpetual futures on crypto-native platforms are preferred for basis trades because their funding rates create continuous carry opportunities[3][10].

Step 2: Calculating Notional Exposure and Achieving Delta Neutrality

Determine Your Trade Size

• Decide your notional exposure based on capital, risk tolerance, and margin requirements.
• For example, if you want to deploy $50,000, you would plan to buy $50,000 worth of DATs and short $50,000 worth of futures contracts.

Achieving Delta Neutrality

• The quantity of DATs long should match the futures short in terms of underlying units (e.g., number of BTC or ETH tokens), not just dollar value.
• Precise matching is essential to avoid directional exposure from price moves.
• Use the current spot and futures prices to calculate quantities:

[ \text{Quantity to buy} = \frac{\text{Capital allocated}}{\text{Spot price}} ]

[ \text{Quantity to short} = \frac{\text{Capital allocated}}{\text{Futures price}} ]

Adjust for any fees or slippage to keep the hedge tight[3].

Step 3: Step-by-Step Trade Execution

1. Fund Your Accounts

• Deposit stablecoins (e.g., USDT, USDC) or crypto to both your spot/DAT and futures trading accounts.
• Confirm margin requirements for futures trading and ensure sufficient collateral.

2. Buy DATs (Long Spot Leg)

• Navigate to the spot market or the DAT trading interface on your chosen exchange.
• Choose order type:
  • Market order for immediate execution but risk slippage.
  • Limit order for price control but risk partial fills.
• Place an order to buy the exact quantity calculated.
• Carefully monitor the fills, noting the average execution price and quantities after fees[3].

3. Short Futures (Short Leg)

• Immediately after completing the spot leg (ideally within milliseconds), go to the futures market.
• Open a short position for the exact same quantity as your DAT purchase.
• Use market or limit orders depending on liquidity and price sensitivity.
• Confirm full fill and note execution price.

4. Confirm Delta Neutrality

• Review both fills and ensure quantities match closely.
• Calculate your resulting position delta to confirm it’s near zero.
• Any mismatch introduces directional risk, known as legging risk.

Step 4: Monitoring and Managing Key Risks

Basis Risk

• Definition: The risk that the difference between spot and futures prices will widen or not converge as expected at expiry[7].
• Mitigation:
  • Monitor basis spreads regularly.
  • Adjust positions if basis moves significantly.
  • Consider rolling futures contracts before expiry to avoid large basis swings.

Liquidity Risk

• Risk of inability to enter or exit positions at desired prices due to low market liquidity.
• Mitigation:
  • Choose highly liquid contracts (BTC, ETH) and exchanges with deep order books[9].
  • Avoid large trades that exceed typical daily volume.

Funding Rate Volatility

• Funding rates on perpetual futures can spike or invert, impacting profitability.
• Mitigation:
  • Track funding rates continuously.
  • Avoid entering trades right before expected funding spikes.
  • Consider hedging funding rate exposure with other instruments.

Counterparty Risk

• Risk that the exchange or clearinghouse defaults.
• Mitigation:
  • Use regulated and reputable exchanges.
  • Diversify across multiple venues.
  • Keep collateral within safe limits and withdraw profits regularly.

Best Practices for Risk Management and Position Monitoring

• Automate monitoring of spot and futures prices, basis spreads, and funding rates using APIs or third-party tools.
• Set alerts for basis deviations beyond your risk tolerance.
• Maintain regular rebalancing to correct for slippage, partial fills, or market moves.
• Use stop-loss or stop-limit orders on futures to limit downside if delta neutrality breaks.
• Keep a trading journal documenting entry prices, fills, and rationale.
• Manage capital allocation conservatively, starting small and scaling as you gain experience.

Practical Example

Suppose you want to execute a basis trade on ETH worth $50,000:

• ETH spot price: $1,800
• ETH perpetual futures price: $1,805
• Calculate quantity:

[ \text{Quantity} = \frac{50,000}{1,800} \approx 27.78 \text{ ETH} ]

• Buy 27.78 ETH (DAT or spot).
• Simultaneously short 27.78 ETH perpetual futures.
• Monitor funding rates which might be positive (you receive funding) or negative (you pay funding).
• Track the basis spread and adjust if it deviates.

Recap and Actionable Takeaways

• Carefully select liquid DATs and futures contracts, favoring BTC or ETH on major exchanges.
• Calculate precise notional exposure to achieve delta neutrality.
• Execute legs simultaneously to avoid legging risk.
• Monitor funding rates and basis spreads rigorously.
• Manage risks through diversification, rebalancing, and automation.
• Start small and scale with experience.

What’s Next?

In Part 3 of this series, we will dive deeper into advanced optimization techniques, including automation, algorithmic execution, and portfolio-level risk controls to enhance your crypto basis trading performance.

By following this step-by-step guide and incorporating robust risk management practices, you can confidently execute the crypto basis trade to capture market-neutral profits while minimizing exposure to directional price risk.

This is part 2 of 3 in our series on Mastering the Crypto Basis Trade: How to Profit by Going Long DATs and Short Futures. This article was automatically generated using AI technology and may contain affiliate links.