Funding rate is a unique feature in the crypto space, applicable only to perpetual futures contracts.
It is a technique that ensures the contract’s value remains closer to the spot market price. It also provides incentives and segments for traders. In this article, we will briefly discuss the following aspects.
KEY TAKEAWAYS
- What is the funding rate, and how is it calculated?
- What is the purpose of the funding rate, and why does it exist?
- How does the funding rate impact the traders?
- How can we use funding rate as a trend analysis tool, a sentiment indicator, and a trading strategy?
What is the Funding Rate in Crypto futures?
The funding rate system is a periodic payment system made to long-term or short-term crypto traders in the crypto market. It is calculated based on the difference between the perpetual contract price and the spot price of an underlying crypto asset. As a thumb rule, the funding rate tends to rise when the market is bullish.
During this time, the long traders on the futures contract will have to pay a funding fee to the traders on the shorter side. Similarly, when the market is on the bearish side, the funding rate turns negative.
It tends to go further down as the crypto market’s bearish run continues. During this time, the short position holders of the crypto perpetual futures contracts must pay a funding fee to the long traders.
Why does the Funding Rate Exist?
Perpetual contracts stand out by trading continuously without an expiry date. Crypto Perpetual futures, aim to shadow the spot market price. Thus, they eliminate the concept of discount or premium, which is present in normal future contracts. This aspect is achieved through the funding rate mechanism of the crypto trading market.
How is Funding Rate Important for Traders?
The funding rate concept in crypto arises from the existence of perpetual futures contracts.
Therefore, the funding rate in crypto futures becomes a primary force that is used to converge the prices of the actual perpetual contract and the underlying crypto asset. In traditional futures contracts, due to the presence of an expiry date, future contracts can trade significantly above or below the actual spot price of the underlying.
However, for the perpetual futures contracts, this cannot be allowed as it would create a distortion in the market and result in undue losses for the traders. The traders can hold on to the perpetual futures contracts in perpetuity, which means that they can hold them unless the trader gets liquidated or exits the market.
Therefore, to solve the problem, the crypto exchange that provides futures trading facilities created a “funding rate” concept. It corresponds to the actual underlying crypto asset’s spot price and ensures that there isn’t too much deviation from the futures contract value to the underlying asset.
How to interpet the Funding Rates and Fees?
Once you can understand the concept behind the funding rates, you can easily interpet it.
- Contango
- The futures contract price is higher than the present price of the underlying asset.
- Has a positive funding rate.
- Indicates a bullish market.
- Traders who holds long positions pay funding fees to those in the short positions.
- Backwardation
- The futures contract price is lower than the current price of an underlying asset.
- It indicates a negative funding rate.
- Backwardation is an indication of a bearish market.
- The traders holding short positions pay funding fees to those who are holding long positions.
What determines the Funding Rate in Crypto Trading?
Two components determine the funding rate: The premium and the interest rate.
The interest rate is a fixed rate that is considered to be higher for holding cash instead of holding an equivalent value of Bitcoin. By default, the interest rate is set at 0.03% per day. But the exchange has the right to adjust the interest rate according to the market conditions.
On the other hand, the premium component reflects why the price of the perpetual contracts tends to follow the trend of an underlying asset. During phases of high volatility, the cost of the perpetual contract and the mark price might diverge. The premium index in crypto trading encourages the contract market price to converge with the spot price. The premium index is calculated using the following formula.
PI= [Max (0, Impact Bid Price-Index Price)-Max[0, Index Price-Impact Ask Price)]/Index Price
Here,
- Impact Bid Price: Average at which the buy queue reaches the impact margin amount.
- Impact Ask Price: Average price at which the sell queue reaches the impact margin amount.
- Index Price: Weighted average price of an underlying asset on major cryptocurrency exchanges.
What is the impact of Funding Fees in Crypto Trading Market?
Funding fees attempt to bridge the difference between future contract prices by managing the pressure on profits. It also increases the liquidation risks the crypto future investors and traders face.
- Profits
If the funding rate increases, there is an increased pressure on the profits realized by the paying side of the funding fee. Therefore, a higher funding rate increases the value of the funding fee and reduces the profitability of the trader on the profit side of the trade.
However, if a trader is on the receiving side of the funding fee, it means that the trader is seeing losses on the funding books. The funding fee would help the traders to reduce some of the losses incurred by them.
- Liquidation Risk
While funding rates can have impacts on profit, they can also pose a liquidation risk if a trader is not aware of it or does not have information regarding it while entering a trade. A high funding fee will bring a trader close to the liquidation value as it eats up their margin money.
This would bring them closer to the liquidation value as the fee would eat up the trader’s margin. It would also reduce the available margin required to keep the position open.
How to use Funding Rate in Trading?
There are four strategies that helps leverage the funding rate in crypto trading.
- Sentiment Trading
The funding rate in crypto market serves as a valuable sentiment indicator. It determines the market psychology and behaviour and also tells whether long or short are presently more aggressive. You can enhance your trading strategy with sentiment trading’s insight and combine with other indicators to make informative decisions.
- Trend Divergence/Confluence
The traders can use funding rates in conjunction with market trends. If the funding rate and price trends are diverging, like if the price moves upward with the funding rate staying negative, it might signal market pressure opposing the trend. On the contrary, confluence between the two aspects can provide more confidence to the trader’s trend analysis.
- Funding Rate Trade
This strategy involves capturing the payments of the funding rate without committing to a specific asset direction. You will have to simultaneously go long in the market and short on a perpetual exchange to execute this strategy. While both the positions offset each other in terms of asset direction, the short position on the perpetual exchange allows the traders to collect the funding rate payments.
- Trading Against the Funding Rate
This is a risky trading strategy. It involves traders going against the market trends for short time frames, such as 1 or 3 minute charts. You must enter the trade on the opposite side ( the side that receives the funding fee ) immediately before the funding rate is updated for the next period. This helps the trader to collect the funding fee as a reward. This strategy is best for the traders on the side of the funding rate that pays the costs. Automated bots help to execute this strategy perfectly.
While the traders look at the potential benefits of these trading strategies, there are challenges and risks associated too. Make sure to employ these tactics as a part of comprehensive trading approach and make sure to consider the specific conditions of the market.
Key Takeaways
- Unlike the conventional futures contracts, the perpetual future contracts allows the traders to hold positions without any expiry date.
- Since the perpetual contracts never settle, exchanges using Funding Rates ensure that futures prices and index prices converge on a regular basis.
- Funding Rates are periodic payments made to or by the traders who are short or long depending on the difference between the spot prices and perpetual market contracts.
- Understanding that crypto funding rates are used to ensure the crypto perpetual future prices remain as aligned as possible to the price of an underlying asset.
Conclusion
The funding rate, which is often misunderstood by the crypto market traders is a crucial element in trading perpetual futures contracts. It reflects the cost of holding a position. Funding Rates play a vital role in aligning the perpetual contract prices with the spot market prices. Having a proper understanding on the funding rates allows the traders to make more informed and better decisions and reduce the downside risk as much as possible. It also improves the upside potential of traders in their trades in the crypto futures market.
Mudrex can help you grasp the nuances of funding rate with informed and updated news and help you enhance your trading strategies and make more informed decisions. Thus, start trading with Mudrex now and elevate your crypto trading journey. Download the Mudrex app from Google Play store to enroll yourself.
FAQ
- What is Funding Rate in Crypto Futures?
The funding rate in crypto market is a feature that ensures the future prices stay close to the spot market price. It is an interest rate that the short and the long traders pay to each other on every funding interval. It takes place typically every 8 hours based on the differences between the spot price and the future price.
- How is funding rate calculated on crypto?
The funding rate calculation considers the discounts and premiums of the future prices relative to the spot price. If the future price is higher than the spot price, the long positions pay to the short positions and vice versa. The rate is adjusted to keep the future prices in line with the spot prices.
- What are the factors influencing funding rate in Crypto?
Several factors are responsible for influencing the funding rate. They are market demands, trading volume, gap between futures and spot prices. Higher demands for long and short positions can increase the rate while the opposite can lower them. External events and market sentiments can also influence the rate.
- Why is Funding Rate essential for the Crypto Traders?
The traders monitors the funding rates closely because they determine the cost of the holding positions in the future contracts. High funding rates can make holding short and long positions expensive over time. It can also influence the market dynamics and the trading strategies. Therefore, understanding the funding rates help traders to make informed decisions.
- How can the traders profit from Funding Rates in Crypto?
The traders can profit from funding rates by strategically entering positions based on the expected rate movements. Like, if a trader anticipates a negative funding rate, they can enter long positions to receive payments and vice versa. The traders have to analyse the market conditions and the funding rate trends carefully for the strategy.
Krishnan is a Bangalore-based crypto writer dedicated to simplifying complex crypto concepts. He covers blockchain, DeFi, and NFTs, with a focus on real-world asset tokenization and digital trust. Previously he has written on Real Estate related assets for NoBroker. Krishnan holds a B.Tech degree from the College of Engineering Trivandrum.
