The basis for Bitcoin is the difference between the spot price and the futures contract price. The concepts of contango and backwardation refer to whether the basis is at a premium or discount. A market is in contango when the futures price is higher than the spot price (premium). On the contrary, a market in backwardation has the futures price below the spot price (discount). In either case, the spot and futures prices should converge - driving the basis towards zero as the contract approaches expiration.
Most assets with futures markets typically trade in contango - with the futures price trading higher than the spot price. This is a function of carrying costs such as interest rates, storage & delivery costs, and insurance premiums. However, the Bitcoin market often fluctuates between contango and backwardation and even experiences periods of extreme contango or backwardation. We take a look at market data during these periods to see if the basis can help investors in determining the direction of the market.
Observing The Basis
Closely tracking the basis for Bitcoin can potentially give investors an indication of which way to lean in terms of market direction. Key areas to pay close attention to are when markets move into backwardation or extreme contango as they can signal potential buying or selling opportunities.
When a market experiences extreme contango, it is quite bearish and often signals an impending reversal. Why is this the case? On a fundamental and psychological level, a market in contango offers incentives for miners and large commercial players to sell futures to hedge and lock in profits. Even more so, when a market moves to extreme contango with Bitcoin futures prices $500+ higher than spot, these large players with significant amounts of Bitcoin are highly incentivized to hedge their position by selling futures at a considerable premium. This can often limit the upward momentum of price and put significant downward pressure on the futures market since miners are the largest and most consistent sellers of Bitcoin. When markets experience extreme contango, these large players hedge their positions. This leaves speculators as some of the only buyers under such market conditions. Large commercial players with strong hands are hedged, while speculators with weak hands are long. Extreme contango often causes market structure to weaken and consequently limits any upward momentum remaining in the markets.
February 2020 Case Study
On Feb 12, 2020, Bitcoin experienced extreme contango on multiple futures markets. On Bitmex, the contango crossed a key threshold of $500 and peaked at $612. Percentage- wise, the Bitmex contango surged above 5% and topped out at 6%. On OKEx, contango crossed the important 3.5% level before climaxing at 4.5%. The price of Bitcoin reached a local top near $10,500 before selling off over the following days.
The extreme contango was also seen on other venues and indicators. That same day, the annualized rolling 1-month basis reached a high of 47% on OKEx and 37.2% on Kraken - indicating extreme contango. Similarly on Feb 12, the annualized rolling 3-month basis topped out at 24.7% at FTX, 22.8% at Deribit, and 22.1% at Bitmex. Extreme contango across multiple venues slowed Bitcoin’s upward price movement and pulled it back down shortly after.
June 2019 Case Study
In June 2019, the Bitcoin futures market on OKEx saw contango rise above the key 3.5% level before peaking at 6.8% on June 22 as price crossed above $11,000. Although this extreme contango did not mark the exact top of Bitcoin’s move, it gave a good warning sign that markets could soon reverse downwards. Four days later on June 26, Bitcoin reached a swing high of just under $14,000 before starting a multi-month selloff.
The rolling 1-month and 3-month annualized basis also saw significant spikes into extreme contango between June 22-27 as seen in the charts below. Once again, extreme contango brought Bitcoin’s bullish move to a screeching halt and gave clear warnings of an impending reversal.
December 2017 Case Study
December 17, 2017 marked Bitcoin’s all time high of just under $20,000. The OKEx futures market went into an extreme 15% contango before reversing and starting a year long bear market. Prior to reaching this point, the basis crossed above the important 3.5% level at OKEx and flashed warning signs of an impending top. The extreme contango here represented bullish exuberance and any speculative gains would come with exceptional risk. The basis once again gave investors an indication that the market was nearing a reversal.
On the other hand, backwardation can often be seen as a bullish signal and an indication of when to go long. When markets are in backwardation, the large players who hedged and shorted the futures at a premium during a contango market, can now close their hedges by buying the futures at a discount. Futures are not useful to miners as a tool for hedging when they are trading at a discount to spot. These large players can sell their holdings on the spot market and are now incentivized to buy discounted futures in a big way to maintain their exposure. In these situations, Bitcoin is being accumulated by strong hands. Backwardation often occurs as speculative sellers lose faith in their holdings and sell into a down market or when a volatile downturn causes a slew of liquidations. Backwardation often results in a strengthening of market structure as exposure is transferred from weak hands (speculators) to strong hands (efficient miners, hodlers). These periods usually signal good long term buying opportunities in Bitcoin.
March 2020 Case Study
March 12, 2020 saw Bitcoin crash nearly 50% as coronavirus fears rocked global markets and brought the economy to a screeching halt. However as Bitcoin sold off, the market went into extreme backwardation with Bitmex futures trading at a $400+ discount to spot. Percentage-wise, this discount represented an approximately -19% backwardation (compared to a 2% contango the day before). At OKEx the basis reached a -15.1% backwardation vs a 0.4% contango the prior day. The large backwardation that day pulled the market back up as speculators were liquidated and strong handed buyers stepped in to gain long exposure.
That volatile day also saw annualized rolling 1-month basis reach a low of -88.9% on Kraken and -154.1% on OKEx - indicating extreme backwardation. Likewise, the annualized rolling 3-month basis bottomed out at -62.8% on FTX, -44.2% on Deribit, and -49.2% on Bitmex. These instances of extreme backwardation halted the downward price movement of Bitcoin and gave long term investors a solid buying opportunity as markets recovered in the following days.
Q3-Q4 2019 Case Study
Backwardation gave multiple signals of potential local bottoms in the second half of 2019. On each of the highlighted dates (July 27, October 24, November 24), the Bitcoin basis at multiple futures exchanges went into brief periods of backwardation. As can be seen in the charts below, each instance marked a local bottom and signaled a buying opportunity.
April 2019 Case Study
Bitcoin broke out of its year long bear market on April 2, 2019. However a day before this breakout, the Bitcoin futures basis at OKEx reached a local low of -1.25% backwardation. The 1-month and 3-month annualized rolling basis also flashed local bottoms at Kraken, Deribit and Bitmex as can be seen in the charts below. Backwardation gave investors an indication that the downside risk was limited in Bitcoin and to potentially start testing the waters after a prolonged bear market. Bitcoin subsequently rallied from $4,100 to nearly $14,000 in the following three months.
The Bitcoin futures basis, when watched carefully, can give investors an indication of turning points in the market. Extreme contango is a sign of overdone bullish exuberance and often indicates an impending top. Backwardation, on the other hand, indicates extreme bearish sentiment and signals potential buying opportunities. Keeping an eye on the basis can be very helpful when trading Bitcoin.
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