In this article we are going to talk about how futures term structure and basis can be a useful tool to traders for directional advantage and identifying a potential bottom. The inverse of these conditions for a potential top.
Futures term structure in crypto is a good sentiment indicator. Term structure being the series of linear futures expirations across a given timeframe offered. Term structure is often described in one of two ways, either a market in contango or a market in backwardation.
A Market in Contango and Backwardation
A market is in contango when futures prices are trading higher and higher at each outward date from the current spot price. Backwardation is the opposite; futures prices are trading at a discount to the current spot price.
In Crypto, contango and backwardation do not apply with the same considerations as traditional markets such as commodity futures. With Bitcoin, when the market is shifting into contango this is an indication of an overall positive and bullish market, this is also representative of markets on average more often than not. When shifting to backwardation, this is an indication of sentiment gone sour. Think of this simply: participants are selling future-dated contracts either hedging or expecting that prices will drop over the course of time.
Trading At A Premium/Discount
The basis is the difference between the spot price and the futures price. If the perpetual swap is trading above the spot we would say it is trading at a premium, if trading below, a discount.
If we are looking to identify a potential bottom, the strength we want to see by bulls in any correction is strength in the spot market. This would be indicated by the spot market trading at a premium (above) the perpetual swaps. In any example we are not talking about short periods of subtle differences, but longer periods where there is a considerable deviation.
There are two ways that we can easily observe basis-
One good tool to pay attention to is the “funding/premium index indicator” on Tradingview. The premium index is after all a derivative of the basis. The other method is to simply observe the basis between spot prices and derivative prices across exchanges by looking at price differences.
One such example of using the premium index would be to observe where Bitcoin currently is right now as the chart below.
In Bitcoin’s short history, there are not many times when continuation to the downside has occurred with the premium index showing this type of negative value.
After price has temporarily found a floor, this type of continued negative value normally precedes moves upward. Whether it is a short term relief rally or a new trend remains to be seen, but statistically, we expect higher prices after this feedback.
This is an indication of continued aggressive positioning, and potentially trapped traders. Traders on the derivatives exchange, with more firepower, are more aggressive in their actions than the spot market, and there is less to show for it. Price is ranging and aggressive sellers are getting into position on the derivatives exchanges in anticipation of the continuation downward. If price takes back levels to the upside, they will be forced to cover. Observing this along with an increase in open interest can be an invaluable tool for identifying where traders are caught off-sides, and catching the turn in this market.
By Ryan Scott (@CanteringClark)