Definition and Profit Mechanism
Carry Trade (also known as Cash-and-Carry Arbitrage) is a market-neutral arbitrage strategy that capitalizes on price discrepancies between spot and derivatives markets. Traders profit by simultaneously buying and selling correlated assets—typically spot commodities and their derivative contracts (e.g., futures or options)—to exploit temporary pricing inefficiencies. The strategy hinges on two key concepts: contango and backwardation.
Contango vs. Backwardation
These terms describe the structure of a futures curve:
- Contango: Forward prices exceed spot prices (common in stable or bullish markets).
→ Favors short spot + long futures positions. - Backwardation: Forward prices fall below spot prices (common in tight supply or bearish markets).
→ Favors long spot + short futures positions.
Why It Works
Arbitrage activity narrows price gaps as expiration approaches. At settlement, derivative prices converge with spot prices, locking in risk-free profits regardless of market direction. Returns depend on the initial premium/discount magnitude.
Execution Framework
1. Contango Setup
- Leg 1: Buy spot asset
- Leg 2: Sell futures contract
2. Backwardation Setup
- Leg 1: Buy futures contract
- Leg 2: Sell spot asset
Critical Rules
- Symmetrical Exposure: Notional values of both legs must match (adjusted for contract multipliers).
- Opposite Actions: One leg buys while the other sells.
- Asset Correlation: Both legs reference identical underlying assets.
Real-World Bitcoin Example
Scenario (T=0):
- Bitcoin spot price: $39,490
- Quarterly futures price: $39,632
Strategy:
- Leg 1: Buy BTC spot
- Leg 2: Sell BTC futures
Settlement Outcomes (T=Expiry):
| Final Price | Spot Leg Profit | Futures Leg Profit | Net Profit |
|---|---|---|---|
| $40,000 | +$510 | -$368 | +$142 |
| $39,000 | -$490 | +$632 | +$142 |
| $39,600 | +$110 | +$32 | +$142 |
Profit remains constant due to arbitrage mechanics.
FAQ Section
Q1: Is carry trade risk-free?
A: Nearly risk-free if executed correctly, but requires precise timing and liquidity. Brokerage fees and funding rates may impact returns.
Q2: Which markets suit carry trades?
A: Highly liquid markets with active derivatives (crypto, forex, commodities). Bitcoin and gold are prime candidates.
Q3: How does funding rate affect profitability?
A: In perpetual contracts, funding fees may erode profits. Quarterly futures avoid this issue.
Q4: Can retail traders implement this?
A: Yes, but institutional traders often dominate due to capital requirements for meaningful gains.
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