Funding Rate: The Demogorgon of The Crypto Upside Down

Why To Know The Funding Rate?

Crypto never sleeps, we all have heard that and the scarcity is what makes it valuable, along with various other reasons. To make profit from the crypto and trade, exchanges provide the marginalized products to their users. There is something which is called Perceptual futures, and it differs from your average futures on stock exchanges. There are many dissimilarities between them, but the main one is perpetual futures that do not have expiration dates. It expires once you get liquidated, or you take the profit.

The question that must be arising in your mind is how does the crypto derivatives exchange keep track of the spot price or what if there is high volatility and there is a huge price difference. Let’s tackle everything one by one.

The major part which holds the ground of the perpetual swaps and does not let them deviate from the spot price is the funding rate. Suppose you are long on Bitcoin for a $100,000 on the perpetual futures, and various others like you have taken a long position, and there are very people on the short side. To keep the future price equal to the spot price, long side traders pay to the short side traders to keep the price in check. It is the simplest definition of the Funding rate without indulging in much of jargon.

What Does Funding Rate Holds?

Every exchange has to calculate the funding rate. Some calculate on an hourly basis, some do on a 4 hour time, and some on 8 hours. Here is an example of funding rate from exchanges. As you can see, every exchange has different rates.

Let’s do a little calculation first: Suppose the funding rate is 0.2% and you have the position of $10000, then you will be paying 10000*0.2%= $20 . This money will go to the short traders and vice versa.

Funding rate has two major things interest rate and premium. Interest rate is fixed for every exchange like for Bitfinex it ranges in between -0.05% to 0.05% ( Data May be Subject to change), and for binance it is 0.03% on a daily basis. The premium is what majorly makes the funding rate. Let me give you an example of it.

We all have seen how the Terra has observed a strong fall in the past and wiped out approximately $60 billion of the investor’s money. During the fall, there was a high volatility in LUNA, which made a approximately a difference of $5 in between the prices of futures and spot. The FUNDING rate of the Luna has seen a huge spike due to the strong volatility. Meanwhile, the premium of LUNA has also observed a spike for the short traders as there were fewer people on the long side.

So, I guess until here, you might have seen the funding rate and little about how it works until here.

Can You Predict something with The Funding Rate?

In a nutshell Positive funding rate implies traders are bullish and negative funding rate implies traders are bearish. Here is a chart of funding rate along with Bitcoin price

Now there is not so much to look at in these charts but if you zoom in and look carefully you will find a correlation. Here is a zoom in version

As you can see, before Jul21, the funding rate had a lot of green spikes and was also very volatile, indicating a good bullish sentiment. After the NOV 21, the spikes has decreased, and from JAN 22, things became neutral. If the BTC funding rate does not spike up until the mid of JUNE, it will illustrate a prolonged bearish market. The neutral funding rates have held in a volatile OI environment , which gives hindsight of demand too long and short in the market through derivatives at the moment. One can also place the trade by looking at the funding rates and also including the various indicators.

But Can You Make Money From Funding Rate?

If you reach upto here, let me show you how to use the funding rate.

The first way:

1: Suppose you have $10000 in your pocket, and you are on FTX, and you want to trade on ATOM, whose funding rate is 0.05%, and the rate is settled three times a day.

2: Keep $5000 in your spot account and then transfer the rest $5000 into the futures account. The price of ATOM is currently $10. So Buy 500 ATOM on the SPOT and short 500 ATOM on the Futures with a 1x LEVERAGE. Trading on both sides makes your portfolio unaffected by the market.

3: After eight hours, if the funding rate remains the same, then close your position. The profit you will be gaining is 500*10*0.05=$250(Charges on the exchanges may decrease the profit). If the funding rate goes below, then reap your profit from arbitrage.

4: If you do this for 365 days, then 0.05*3*365=55%. You will get an annualized return of 55%

The Second Way

1: Find out the crypto, which has different funding rates on two exchanges. For example, if AXS has a funding rate of -0.225% on Okex and 0.01% on Binance.

2: Long AXS on okex and short it on the Binance.

3:When the funding rate on the exchanges comes to a common point, take the profit. This method might be difficult to do but can give good returns. (A huge dissimilarity between the rates can also work)

Note: This is not financial advice; one should use this method at their own risk

Is The Demogorgon Not That Bad?

Funding rate has been designed by the people who wants to see crypto flourish. It has been made for the investors and to increase the adoption of crypto derivative products. But one should trade carefully because who knows what is in that UPSIDE DOWN.