Funding Rates Explained: Trading Perpetual Futures with Leverage
The crypto ecosystem offers various tools and products for trading and speculating, such as arbitrage, staking, etc. However, perpetual futures contracts are the most used tool when trading cryptocurrencies. With that in mind, it is exciting to understand not only perpetual futures but also a key data point that influences its results: funding rates.
Funding rates are vital when making decisions on perpetual futures, especially if you wish to make an informed decision and reduce your risks.
With that in mind, this article will serve as a basic introduction to funding rates, covering perpetual futures contracts and leverage.
Before we explain what futures are, it is first vital to introduce derivatives.
A derivative is a contract whose value is determined by the price and fluctuation of an underlying asset. While derivatives serve many purposes, their main one is hedging against price variations of underlying assets. There are many types of derivatives, and among them are futures.
What Are Futures?
A futures contract is an agreement between two parties to buy and deliver an asset at a future date previously determined by the ones involved in the negation. Thus, futures are standardized contracts traded on exchanges with which traders can hedge their risk or speculate on the price of a given asset. These contracts represent that both parties must fulfill their agreement to purchase or sell the underlying asset.
However, not all futures are the same, and some offer different propositions to users.
Perpetual Futures vs. Traditional Futures: How Are They Different?
While both perpetual and traditional futures allow traders to speculate on the price of an underlying asset, they have a crucial difference from each other: the expiry date. Let’s go in parts.
Traditional futures contracts have an expiration date. When this date is due, the contract price converges with the spot price, a process called settlement. Usually, traditional futures contracts settle monthly or quarterly. Once the settlement takes place, all open positions expire.
The expiry date is how a perpetual futures contract, usually offered by crypto-derivative exchanges, differentiates from its traditional counterpart. With perpetual futures, traders can hold positions and speculate on future price uncertainty without an expiry date, which means there is no need to keep up with many delivery dates. Instead, for example, traders can hold a short position for as long as they want, only stopping in case of liquidation.
However, since perpetual futures don’t settle traditionally, exchanges require a mechanism to guarantee that futures and index prices converge. This mechanism is called the funding rate.
What Is Funding Rate?
Funding rates are periodic payments between long or short traders. These payments are based on the difference between perpetual contract markets and spot prices. They maintain the price of perpetual futures contracts reasonably close to the asset price in the spot market. As a result, traders will either pay or get funds based on open positions.
Understanding the funding rate of a perpetual futures contract can reduce the risk of a given trade, which is an excellent benefit that perpetual futures have over traditional futures. That is because the funding rate is the mechanism that provides price stability between the mark price and the index price (target price).
This process encourages traders to exchange their derivatives depending on the price difference. For example, to simplify, sell when the mark price is high relative to the index price and buy when the mark price is lower than the index price. So, understanding the funding rate offers an opportunity of making more assertive decisions long term. However, keep in mind that the risk of perpetual futures also relies on your position size.
Thus, to take advantage of this mechanism, it is in the best interest of speculators to know how to calculate the funding rate.
How Is the Funding Rate Calculated?
Depending on the exchange, the futures funding rate might be calculated using different mechanisms. However, there is an overall understanding of determining the funding rate.
The funding rate is calculated by considering two main factors: the interest rates for trading pair currencies and the Premium Index. The interest rates will differ depending on the exchange being used but are usually fixed at a certain percentage.
The premium will vary based on the price difference between the perpetual contract and the mark price. The more significant the difference between the two prices, the higher the premium. Thus, a low premium would mean a narrow spread between the two prices.
The results of the calculation can either yield a positive or a negative. In short, it means the following:
Price of perpetual swap > underlying price = positive funding rate
Price of perpetual swap < underlying price = negative funding rate
This means that if the funding rate is positive, the price of the perpetual contract is higher than the mark price. In this scenario, long positions pay shorts.
Conversely, following this logic, a negative funding rate means that the perpetual prices are below the mark price. In this latter result, shorts positions pay long traders.
Funding Rates Correlation with Leverage
As mentioned previously in this article, futures funding rates are calculated based on interest rates and premiums. Thus, buyers and sellers can know if the price of the perpetual futures contract is higher or lower than the mark price. However, it’s important to remember that leverage on these trades can highly affect the result of such an investment.
Generally, in the blockchain ecosystem, futures contracts do not require the speculators to use 100% of their holding for trading the derivative product. However, since futures contracts have an expiry date, speculators are more at risk if they don’t know what they’re doing. But for perpetual contracts traders, one can keep the derivative contract for as long as one likes.
Thus, funding rates’ calculations have to consider the degree of leverage employed. Due to this fact, they can significantly influence one’s earnings and losses. Even in low-volatility markets, a trader who pays for funding may incur losses and be liquidated when using significant leverage. However, the scenario is more attractive when it comes to collecting funds. It can be quite profitable, primarily if the trade occurs in range-bound markets.
As a result, traders can create trading approaches to capitalize on Funding Rates and profit even in low-volatility markets. This encourages traders to take positions that maintain perpetual contract prices aligned with spot markets.
A great example of how traders can do that is by looking for crypto exchanges that offer excellent leverage conditions and tools, such as FTX, Bitmex, and NFTperp.
NFTperp is a different type of decentralized and community-owned DEX designed explicitly for everyone to gain exposure to blue chip NFTs like BAYC and CryptoPunks. And unlike traditional AMMs, users can long or short any assets’ perpetual contracts with up to 5x leverage. Thus, NFTperp allows traders to take advantage of leverage, and long or short NFTs they usually wouldn’t be able to!
Why Are Funding Rates Important?
As explained, funding rates allow traders on the blockchain to make informed decisions when speculating with perpetual futures. But how do funding rates enlighten traders? Speculators can take some crucial outputs from understanding and interpreting funding rates.
In finance, including the crypto ecosystem, a bull market indicates a thriving market, while a bear market refers to a decline in prices. It is in the interest of every trader to know which to speculate on – funding rates can provide that. But let’s go in parts because it is a bit more complicated than that.
Perpetual contracts have an embedded rate charged periodically to make sure that there are no imbalances risks. Thus, buyers’ and sellers’ open interest is matched at all times. Therefore, crypto funding rates are historically correlated with the overall trajectory of the underlying asset. The correlation indicates that historical Funding Rates do not determine spot markets; instead, the exact opposite is seen as the truth. The graphic below depicts the 30-day association between Funding Rates on Binance and spot Bitcoin (BTC) prices (in USD):
The chart above demonstrates how funding rates have fallen as Bitcoin futures prices have retraced from the end of 2021. The increased funding rates reflected market confidence in future upside prospects. Nonetheless, many traders were aware of the increased funding fees, which helped futures prices align with the spot. This can be applied when trading any futures, be that based on Ethereum, USDT, etc.
Perpetual swaps are by far the most actively-traded product in the crypto ecosystem. Since most crypto-derivatives exchanges use a funding rate method to ensure that contract prices are always in sync with the index, this mechanism is vital to making informed decisions. These rates change when asset prices rise or fall, influenced by market forces.
Thus, it is safe to say that crypto funding rates play an essential role in the perpetual futures market. In funding rates, traders can find an opportunity to optimize their gains on perpetual futures and manage their risks.