In traditional finance markets, many are familiar with futures contracts and futures trading, whereby there is a daily mark-to-market, settlement and expiry date for these contracts.

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However, in the cryptosphere, a new class of asset called “”perpetual futures” has emerged to give futures contracts the added dynamic of having no expiry dates. This means that traders of these futures contracts are “perpetual” or seem to continue forever and can profit from the funding rates of these assets.

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What are Cryptocurrency Perpetual Futures?

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In conventional markets, futures contracts are priced based on the forward looking market price of an underlying asset, have a specific expiration date and can be settled physically or financially. 

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Perpetual futures are designed to trade close to the underlying asset price, do not expire or settle and can be held indefinitely.

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And traders can earn passive income through the funding rate.

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Profiting from Funding Rates

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Since perpetual futures contracts have no expiry date and make use of a funding rate mechanism to periodically pay out profits to long or short traders by comparing the perpetual price to the underlying spot price. 

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Users who are savvy enough to spot when the funding rate is negative or positive will be quick to take longs or shorts on the other side of the funding rate to profit passively from this peculiar mechanism in the crypto markets.

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What are Funding Rates?

Positive Funding Rates

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When the funding rate is positive, the price of the perpetual futures contract is higher than the mark price, and traders who are in long positions will have to compensate by incentivizing traders who are short. This is because the market is currently in “contango”, meaning that the futures contract price is higher than the spot price of the underlying asset.

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Thus, a positive funding rate indicates that the market is bullish and this sentiment is favorable for traders who are long. Therefore, traders who are in long positions will have to pay funding fees to traders who are in short positions.

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Negative Funding Rate

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Contrastingly, when the funding rate is negative, the price of the perpetual futures contract is lower than the mark price, and traders who are in short positions will have to compensate by incentivizing trades who are long. This is because the market is currently in “backwardation”, meaning that the futures contract price is lower than the spot price of the underlying asset.

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Likewise, a negative funding rate indicates that the market is bearish and this sentiment is better for traders who are short. Therefore, to maintain equilibrium between longs and short positions, shorters will have to pay funding fees to traders who are in long positions.

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Why Traders use Funding Rates in their Strategies?

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Depending on the volume, contract amount, leverage, strategy and risk appetite of the traders, profiting from holding onto positions that capitalize on crypto funding rates can be very lucrative for traders in the long run.

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This not only generates income passively but also relaxes the trader into his strategy by making a plan and trusting in his anticipation of the market’s overall direction.

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The funding fee is usually a small percentage of the position size and is generally calculated at certain intervals, the most common being 8 hours for many exchanges. 

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Funding rates are important because they maintain an alignment between perpetual futures contracts prices and the underlying spot asset price by incentivizing certain trading behaviors depending on the market’s bullishness or bearishness.

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Understanding funding rates will provide insights into traders’ sentiments and help a trader make more savvy decisions.

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This strategy is also called “funding arbitrage” and can offer a low risk option to profit off the crypto markets because funding rates differ amongst exchanges.

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What do they mean?

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Funding rates can also signal reversals in the market due to the overcrowding of total longs and short positions, or whether traders are countertrading a trade - as demonstrated by a decreasing funding rate with a rising price.

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Some exchanges settle these every 8 hours and some do it hourly.

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Coinglass is a good website to monitor funding rates across different exchanges to help with your trading.

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https://www.coinglass.com/FundingRate 

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