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Bitcoin Basis Trade Gains Hedge Fund Interest: Is a Short Squeeze Brewing?

Last Updated June 29, 2024 11:12 AM
Giuseppe Ciccomascolo
Last Updated June 29, 2024 11:12 AM

Key Takeaways

  • Hedge funds are using the basis trade to profit from the gap between Bitcoin futures prices and spot prices.
  • This involves shorting Bitcoin futures (selling high) and simultaneously buying spot Bitcoin (buying low).
  • A surge in hedge funds entering the basis trade could trigger a short squeeze, pushing prices higher.

While Bitcoin spot exchange-traded funds (ETFs) have been raking in billions since January, hedge funds are taking a different approach. They’ve been shorting Bitcoin futures at record levels, seemingly betting on a price drop.

But there’s more to the story. Many hedge funds are also capitalizing on the “basis spread” – the gap between Bitcoin futures and spot prices – through a strategy called the Bitcoin basis trade. And it’s not the only strategy Bitcoin traders can use.

Hedge Funds Capitalize On The Basis Spread

Since January 2024, US-based Bitcoin spot ETFs have attracted significant investment, accumulating over 873,000 Bitcoins – worth over $50 billion – according to official data . This represents a hefty chunk – over 4% – of the total Bitcoin supply.

However, while investors are piling in, hedge funds are taking a different approach. They’ve been shorting Bitcoin futures contracts on the Chicago Mercantile Exchange (CME) at record levels. These “short” bets involve agreements to sell Bitcoin at a predetermined price in the future.

But it’s not all doom and gloom for Bitcoin believers. While some hedge funds might be betting on a price drop, many are utilizing a strategy called the “Bitcoin basis trade.” This strategy exploits the price difference between Bitcoin futures and the actual market price (spot price).

The total value of the open interest for Bitcoin short positions
The total value of the open interest for Bitcoin short positions among hedge funds (dark blue) has shot higher this year. l Source: CME/Finimize

Bitcoin futures often trade at a premium compared to the spot price, known as contango. This creates an opportunity for hedge funds. They can short Bitcoin futures on the CME – selling at the higher futures price and simultaneously buying an equivalent amount of Bitcoin on the spot market at the lower spot price.

The gap between futures and spot prices typically shrinks as the futures contract nears its expiration date. To lock in profits, hedge funds then buy back the shorted futures contracts and sell their spot Bitcoin holdings. This allows them to pocket the initial price difference (basis spread) minus any fees and borrowing costs.

The key for hedge funds is timing. A favorable basis spread (often exceeding 1%) can be lucrative, especially during volatile periods where the spread can jump to 4%. However, these opportunities are short-lived, as hedge funds quickly move in to capitalize, closing their positions within days and capturing those profits.

What To Expect For BTC Price

The gap between Bitcoin futures and spot prices has recently narrowed. This is occurring alongside compressed Bollinger Bands, indicating low volatility. Similar to a coiled spring, Bitcoin is likely poised for a significant price movement, either upward or downward.

If more hedge funds enter the basis trade, it could become saturated, squeezing profit margins. This might lead them to close their short positions by buying back futures contracts. Such buying pressure could trigger a short squeeze, pushing Bitcoin prices higher.

While a short squeeze could drive prices up, the move could also be downward. There are three potential ways to play this: buying Bitcoin, aka the directional bet: if traders expect a price surge due to a short squeeze, they’d buy Bitcoin through a wallet app, broker, exchange, or ETF.

Then, there’s the basis trade or non-directional bet, where a trader becomes their own hedge fund. Traders can buy spot Bitcoin – ETF or exchange -, short CME Micro Bitcoin futures, or wait for volatility to return – and potentially a short squeeze – to widen the basis spread. Then they can sell their spot Bitcoin and close the futures position to pocket the spread minus fees.

The last one is going short on Bitcoin. If a trader is feeling bearish, it’s possible to sell CME Micro Bitcoin futures – without buying spot – but using a stop-loss order to limit potential losses if the price rises.

Three Indicators Suggest Bitcoin Will Grow

Bitcoin’s been stuck in a holding pattern since March 2024, leaving investors wondering if the bull run is over. If you’re wondering how the price will perform, there are key indicators to watch out for.

One is the Bitcoin Pi Cycle Top Indicator. Unlike stocks with their clear crash signals (20% dips), Bitcoin experiences frequent, dramatic drops. Analysts use the Bitcoin Pi Cycle Top Indicator, which has accurately predicted four major peaks within three days. The Pi Cycle compares Bitcoin’s short-term (111-day) average price with its long-term (350-day) average price, doubled. When the short-term average rockets past the long-term average, it might signal a sell-off.

The good news is that the short term hasn’t broken above the long term yet, suggesting Bitcoin has room to climb before the bull run ends. If the Pi Cycle triggers, it could even enter a final “euphoria phase” – a rapid price surge—similar to past peaks. But if the price dives below the short-term average first—like in late 2019—things could get shaky in the short term.

The second indicator to watch is Bitcoin’s Supply Profitability Gauge. This indicator tracks the percentage of Bitcoin‘s supply held by investors who are currently in profit. In the early stages of bull runs, this number climbs above 90%, signaling long-term holders are starting to cash in. Then, as Bitcoin blasts off and enters “price discovery mode,” the euphoria phase kicks in, with the profitable investor percentage hovering around 90% as shorter-term traders join the fun.

Bitcoin’s available supply with in-profit holders
The percentage of Bitcoin’s available supply whose holders are in profit is currently at 93.4%. l Source: Glassnode/Finimize

Currently, we’re at 93.4%, suggesting we have 3-9 more months of sunny skies before potential storm clouds gather. A drop below a key level (around 65%) could indicate those clouds are rolling in sooner than expected.

Finally, there’s the Fibonacci Extension, which is based on the number 1.618. Here, traders need to look at its inverse (0.618). In past bull runs, Bitcoin surged beyond its 0.618 Fibonacci extension level before peaking. This bull run’s extension level sits around $100,000.

If history repeats, Bitcoin could shoot past $100,000 before topping out. But it’s important to note that past performance doesn’t guarantee future results. If Bitcoin breaks below its May low of $56,500, that could signal a shift in investor sentiment. A break below its current trading range could mean a wait before Bitcoin reaches new highs again.

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