Delta-neutral 101

Delta-neutral is a strategy that reduces the risk of price movement of an asset. It stays neutral whether price goes up or down, profiting from the position.

Delta-neutral 101
Photo by Monti Timpanogus / Unsplash

The information presented is for educational purposes and does not constitute investment advice or a solicitation to buy or sell assets or make financial decisions.

Delta-neutral is a strategy to reduce the risk of price movement in underlying assets.

Delta is the Greek word for "change". Achieving delta-neutral means the overall delta is zero, that it should not change. Whether the price goes up or down, the goal is to be neutral and ideally profit from this position.

⬆️+⬇️ = delta neutral

To better understand this concept, the article is divided in these sections that include key terms:

  1. Perpetuals;
  2. Funding rates;
  3. Basis trades and long & short;
  4. Can this be automated?
  5. How to perform the basis trade

1. Perpetuals

A perpetual future is the promise to buy (long) or sell (short) a given asset at some point in the future. They have no expiry date, hence the term perpetual future, commonly abbreviated as perp. A perp remains in effect until its position is closed by the trader.

It is possible to long or short a perp. A long position is taken if it is believed the price of an asset is going up or short if it is believed the price of an asset is going down. Going long is buying the asset to sell it at a price in the future. Going short is borrowing *to sell* the asset to buy it at a price in the future.

The funding rate keeps the perp going. Perpetual futures differ from traditional futures in the way they keep the perpetual contract ongoing. They do this with funding payments, a mechanism to incentivise traders to keep the price of the perp in line with the price of the spot.

Leverage can be used with a perp. These contracts can be leveraged by posting collateral. For example, if you're using 3x leverage and you have 1000 USDC in spot, the exchange where funds are deposited will allow long or short up to 3000 USDC worth of the asset's perp.

Why use a perp?

A perp is commonly used to hedge a spot position against price fluctuations. Suppose SOL was bought spot, so the position is long. To protect against a price drop, a short position of the same amount is opened in SOL-PERP creating a delta-neutral overall position.

Here's what could happen in that scenario:

  1. If the price of SOL-SPOT drops below SOL-PERP, funding turns positive, longs pay shorts.
  2. If the price of SOL-SPOT rises above SOL-PERP, funding turns negative, shorts pay longs.

In the second scenario above, since the price of SOL rises and a short SOL-PERP position is opened, it will be charged a fee and pay the longs. However, the spot SOL is worth more now, potentially making up for the small amount of funding being paid and the trade could be exited for profit.

2. Funding rates

Being delta-neutral reduces exposure to price movements. However, as a result, the position will have exposure to the funding rate, the most important factor of a delta-neutral strategy using a basis trade (more on that later).

The funding rate is hourly interest payments exchanged between longs and shorts and it can either be positive or negative. When a funding rate is positive, long traders pay a small fee to short traders and vice versa when it's negative:

  • If price of spot < price of perp (price went down), funding is positive, and longs pay shorts.
  • If price of spot > price of perp (price went up), funding rate is negative, and shorts pay longs.

For example, if the funding rate of SOL is -0.0011% and I'm $1000 long on the SOL-PERP contract on FTX, then traders who are short will pay longs. The amount received would be $1000 * 0.0011 = $1.1 at the close of the hour.

Funding rates are usually hourly payments, depending on the exchange. FTX and dYdX are hourly, Binance and Bybit have eight hour intervals and Mango settles every 5 seconds. Check with the preferred exchange (CeX or DeX).

Why use funding rates?

Funding rates exist to incentivise traders to keep the price of the perpetual in line with the price of the spot of the asset.

They have been historically more positive than negative, and there are two main reasons for this:

  1. There are more long traders than short traders in crypto.
  2. Cryptocurrencies such as BTC and ETH are cheaper to borrow than stablecoins such as USDC and USDT. This is because going long on BTC is equivalent to borrowing USD (to buy BTC); and going short on BTC is equivalent to borrowing BTC (to sell BTC). So going long on BTC should cost more than going short.

3. Basis trade and long & short

The goal of a basis trade is to capture funding payments from perpetual futures contracts and do so without minimal price exposure to the asset.

Basis trade is taking advantage of positive and negative funding rates when an assets' spot and perpetual differ.

Long & short is when funding rates on various exchanges differ significantly. This allows for a trade where a position is long on one exchange, short on the other, and both pay a funding rate.

It is possible to long the spot and short the perp, or short the spot and long the perp. The way this is done depends on whether the funding rate is positive or not, and if the funding payments are worth it.

Why use basis trades?

The goal of a basis trade is to get funding payments without price risk from market volatility. Going delta-neutral like this allows a position to hedge out this price risk, because there is an equal and offsetting long and short position of an asset.

It's not without its downsides though, because a basis trade involves a more active management style than other types of trades.

4. Can this be automated?

Basis Markets has been able to automate the process of profiting from delta-neutral trades. It's the core strategy used in our Decentralised Basis Liquidity Pool (DBLP).

The DBLP is the decentralised liquidity pool that uses data from the Basis Trade Engine (BTE) to perform automated delta-neutral trades. The DBLP is currently deployed on dev-net until it can be made permissionless and fully decentralised to launch it on mainnet.

The Basis Trade Engine (BTE) requires a Basis NFT to be held in order to use the application. The DBPL, on the other hand, can be used on devnet without an NFT.

Using these strategies ourselves, we saw the potential delta neutral returns can deliver however, finding optimal returns is time consuming  due to the sheer number of potential trades across exchanges. So we set out to create a tool to automate this process, the Basis Trade Engine (BTE)

Why use automation?

Automation saves time and effort in what otherwise would be manual and time consuming processes. The DBLP was built to automate these delta-neutral strategies using the BTE to feed it data.

The BTE is a dashboard that helps spot profitable trade opportunities across exchanges. Users of the BTE still have to execute their own trades, as it does not execute trades on a users behalf. Learn more about the project here.

5. How to perform the basis trade

While it may seem complex, it’s relatively simple. This type of strategy does need a more active management style than other types of trades, it is essential to watch out that the funding rate doesn’t turn against the position (more on that in the risks section below).

There are a number of exchanges, both centralised and decentralised, that have perpetuals. Examples are dYdX (DeX), Mango Markets (DeX), FTX (CeX), Binance (CeX) and several others. You can read a complete list in our discord post.

  1. Deposit collateral (eg.: USDC) into an exchange that has perpetuals. FTX has dozens of PERPs, such as BTC-PERP, ETH-PERP, SOL-PERP and many more.
  2. Open a perp position for which you aim to collect the funding rate. Go long if the funding rate is negative, go short if the funding rate is positive.
  3. Open the opposite spot position relative to the perp opened from the step above. If short on the SOL-PERP,  long on the SOL/USD (buy the spot).

Delta-neutral risks

Crypto is volatile and this blog post does not constitute financial advice. Be aware that there is the possibility of losing funds on any type of trade. The risks associated with a basis trade are the liquidation risk and interest rate risk.

Liquidation risk. The basis trade, being delta-neutral, needs active management. The user needs to have the required amount of margin to avoid liquidation.

Interest rate risk. Funding rates need to be monitored to make sure they are not moving against your position. For example, you may be short on a perp with a positive funding rate and it suddenly turns negative.

Conclusion

Become delta-neutral by going long or short in the asset's perp and taking the opposite side by going long or short an equal amount on the asset's spot.

The DBLP is a tool that performs these trades automatically. It's working on devnet until it can be launched on mainnet after making it fully decentralised due to regulations.

Perpetual contracts and funding rates - YouTube video
How to Profit From High Funding Rates - article
Guide to Sustainable Farming - article
A Crash Course on Perpetual Protocol - article
Making money with delta-neutral trading using perpetual swaps - article