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Derivatives exercise 2

Updated: Jul 29, 2023

It's been a while, let's do another derivatives exercise.

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Recently bitcoin did a classic short squeeze where there was a nice and straight forward opportunity to enter a scalp long and take advantage of offside market participants. If you don't know what "offside" means I recommend that you go through my previous articles, but to summarise: badly positioned traders that are at high risk of getting run over.

This short squeeze took place on the 28th of May 2023. Leading up to the squeeze there was, as is usually the case with squeezes, a sudden and significant build-up in open interest (OI). I actually ended up arguing with some experienced traders about whether this OI increase was mostly due to directional long or short traders. In my opinion there were some clear signs that it was mostly shorts piling on. This will be the main focus of this article. Most of you already know what a short squeeze is, no need to explain that further, instead I'll go over how you can look for clues to figure out whether people are longing or shorting.

Let's take a look at some of the biggest derivatives contracts in the market and how people were positioned on them.

Often times you'll see similar behaviour on all of the biggest exchanges at the same time, but sometimes the data is more clear on one contract than on others. In this case the Bybit USDT perp painted a pretty clear picture so we'll start with this one.

Situation: we see a sudden increase in OI on the 28th of May.

How is the market positioned?

First clue: based on recent price action in combination with OI we can see that the market is seemingly short biased. OI rising while price goes down implies a short bias, that's just derivatives basics (check my previous articles). It's reasonable to assume that the market is still in the same headspace on the 28th of May.

Second clue: funding regularly dipped negative, even while price was moving up ever so slightly. Again this hints that there's a short bias dominating.

Third clue: on that initial small pump as soon as the daily opened on the 28th, OI collapsed a little. When OI goes down while price moves up it typically means that shorts are closing. Again this implies a short bias. When there's already a meaningful amount of OI in the system I often look at a very low timeframe chart, like the 5 minute for example, and watch how OI reacts to very small price pumps or dumps. Again, when OI goes down while the price moves up it means that shorts are closing. When OI goes down while the price moves down it means that longs are closing, or to be a 100% accurate it simply means that more longs are closing than opening.

Even if you're not trading on very low timeframes, it's useful to look at it just to gauge how OI reacts because it gives you a hint as to which positions are sensitive to the volatility.

Fourth clue: the CVD stays relatively muted, in fact it even goes down a little, all while the build-up in OI is happening on the 28th. If these were market longs then surely the CVD would be skyrocketing, but it's not.

Fifth clue: while the great OI build-up happens, funding drops negative again and stays there the entire time as OI is moving up.

All of these clues together give you a pretty good idea that the open interest build-up mostly consists of directional shorts who are going against the trend (up) in the short term and they're also going to be paying funding just to keep their shitty positions open. This is OI build-up that happened over a very short time period as well so we can also assume that these are mostly scalpers just like us. Scalpers are by default much more sensitive to volatility than swing positions, so they can pretty easily get squeezed.

Although Bybit painted a pretty clear picture, honestly as clear as it gets, it's useful for the sake of completeness to take a look at some of the other big perpetual swap contracts to check if we see similar activity or not.

The Binance USDT perp isn't as easy to read as the Bybit one because it doesn't have negative funding. However there are some other clues that tell us something valuable just like what we've seen with Bybit.

For example, we can clearly see that during recent price action the market was heavily short biased with massive OI swings up as price moved down and a rapid depletion of OI as price moved up.

We also see that just like with Bybit, on the initial daily open mini pump on the 28th, OI collapsed a little bit. And even though funding isn't negative, it's also not very high because it's just sitting at baseline.

So again, there are some signs that the market is short biased.

Finally we have the OKX USDT perp, and then we've had all of the most important perp contracts

On OKX we also saw a rapid increase of OI on sharply declining funding just like what we saw on Bybit.

If the price goes up with increasing open interest, and we assume that it's mostly longs, then you would also have to assume that funding starts rising significantly. The fact that on both Bybit and OKX funding actually drops into the negatives, and it remains baseline (0.01%/8h) on Binance, is a very strong indication that the market is shorting.

I think we can come to a conclusion now. It was pretty clear that people were fading an uptrend, and this was a prime opportunity to take advantage of some horribly positioned shorts. Anywhere in the blue box on the chart below could you have comfortably entered a scalp long.

Only one more question remains: when to exit?

It's pretty simple for me: I usually don't set price targets, I just look at the derivs data. When the short build-up gets squeezed, it's time to exit. As you can see on the chart above, once that entire OI build-up got crushed, the market also locally topped out. That's not a coincide, this is usually what happens. Funding also started to reset once those shorts got smoked so clearly the thesis has played out, time to get out if you haven't already.

That's it for this exercise.


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