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Funding Rates: A Beginner’s Guide

Traditional vs. Perpetual futures

Traditional futures contracts always come with an expiry date. After this expiry begins the process of settlement. Generally, the settlement is done on a monthly or a quarterly basis where the contract price meets the spot price subsequently closing down all open positions. 

There are several crypto-derivatives exchanges that allow traders to invest in perpetual contracts. These are structured along the lines of a traditional futures contract but there is a prominent difference between the two. In conventional futures contracts, there is an expiry date that needs to be tracked regularly, especially near the maturity months. However, when you own a perpetual contract, there is no need to worry about expiry dates. You could even keep a short position for almost perpetuity unless there is a risk of having your assets liquidated. Thus, you may eventually realize that perpetual contract trading could be a lot like trading pairs in spot markets. Read more about what are digital assets

Unlike traditional futures, perpetual contracts do not settle and thus, there is a need for a system that makes sure that the index prices and the futures prices coincide regularly. To do this, exchanges use a mechanism that is referred to as Funding Rate. 

Funding rates- definition

Essentially funding rates are payments made to investors. Whether the crypto investors go on to take long or short positions in the market depends on the difference in prices of the futures market as well as the spot market. Whether the investor needs to pay or if they have to be paid is decided on the basis of their open position. 

The financing rate ensures that the prices prevailing in the two different markets do not remain poles apart forever and is calculated multiple times in a day. The possibility of a long-lasting divergence in the prices that prevail in both futures and spot markets is curtailed by crypto funding rates.

Factors influencing the funding rates

There are two main aspects of the funding rate:

  1. The interest rate
  2. The premium

During highly volatile periods, the mark price and the price of perpetual contract could diverge which causes the premium to rise or fall accordingly. So if the spread is large, the premium will be high while if the spread is narrow, the premium would be low.

In situations where the funding rate is actually positive, the price of the perpetual contract will be more than the mark price. As a result, traders who hold long positions are also paid short. The opposite of this where short positions pay for long happens when there is a negative fund rate. Do note that funding rates are always paid peer-to-peer. 

What is the impact on traders?

Funding rates could play a big role in deciding your profits and losses. This happens because when funding is calculated, it also takes into account the leverage amount. If high leverage is used and the trader also pays for funding, they may have to incur losses even when the market is less volatile. Contrary to this, collecting funding could be profitable, particularly in markets that are bound by range. Hence, traders could come up with new strategies to be able to make the most of funding rates and thus earn profit in low-volatility markets as well. 

Funding rate and market sentiment

As a pattern that many experts have observed, crypto funding rates are often linked to the overall trend of its underlying asset. This correlation implies that with higher funding rates, traders opt for perpetual contracts which ensures that the market prices are well aligned with those in spot markets. 

At the moment, there are a handful of exchanges that offer perpetual contracts. Usually, traders like to go with the exchanges that support low funding rates as this can play a major role in determining profit or losses. While the funding rate changes as per the asset it is associated with, the general average across top exchanges stands at 0.015%. 

How does it help make money!

How can you earn a passive income via funding rates? One way to do so is to buy as well as short exactly the same amount of cryptocurrency you’ve invested in. With this, you can in a way even out the negative and positive funding rates as then technically, you do not have a position in that crypto market. Short trading funds get credited on an hourly basis though remember that it would ultimately be a net amount as you would have positive trades as well. 

This method is used by several big firms to earn a large amount of money in a short span of time. This is called defunding. 

Capitalizing on funding rates

Funding rates can also help you earn profit via delta-neutral arbitrage. BTC perpetual futures in this case trade at a premium to spot which leads to positive funding rates. So traders could purchase a single unit of bitcoin and the equivalents of it can be shorted on perpetual futures. You can thus capture the funding rate without giving in to the volatile market. 

You can also try a more advanced strategy where you go long and short on different exchanges. Since then your trades are exposed to more participants, and the funding rates will also be different. Another way to make the most of funding rates is to trade stablecoins such as USDT. Since most institutions try to cut down the risk factor, stable assets generally face negative funding. High leverage is avoided in delta-neutral profits as protecting capital and avoiding risk is key. 

Is it for you?

In a sideways market like the one we work in, delta-neutral profits are best suited. Even though on the face of it this may appear to be easy money, this is essentially automated funding led by bots and hence it comes with a fee.

If you also take the exchange fee into consideration, any profit can be nullified without proper calculations and an appropriate assessment of the risk-reward ratio. However, do note that the cryptocurrency market can be very inefficient when it comes to arbitrage trading and hence, retail investors such as you could also earn profit.

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