Table of Content
What is funding rate (FR)?
How to check funding rate?
How to calculate funding costs?
How to use funding rate for arbitrage?
Using funding rate to determine overbought and oversold
Some people claim that funding rate arbitrage can achieve an annualized return of 30%-40% with no risk. Is funding rate arbitrage really "risk-free"?
Traders who are new to the contract market may have only a partial understanding of the concept of funding rate (FR), not clear about its principles, how to check or calculate it, and thus unable to use it to gain advantages and avoid disadvantages in trading.
What is Funding Rate?
Funding Rate is a concept unique to Perpetual Contracts. As we know, conventional futures contracts have a delivery date, so as the delivery date approaches, the futures price in the market will naturally converge with the spot price, ultimately remaining consistent. However, Perpetual Contracts are a special type of futures contract that has no delivery date, so in order to constrain the price of Perpetual Contracts and make them converge with the spot market price as much as possible, the exchange introduces Funding Rate.
The Funding Rate mechanism can be traced back to May 2016 when BitMEX first introduced Bitcoin-based Perpetual Contracts. In order to ensure that it corresponds to the spot index price, BitMEX pioneered the Funding Rate mechanism, which has since been adopted by other cryptocurrency derivatives exchanges.
Funding Rate can be used to anchor the spot price. When the Perpetual Contract price deviates from the reasonable price difference with the spot price at a certain moment, the Funding Rate will forcibly pull this deviation back to the reasonable level. Generally speaking, the greater the deviation from the market, the higher the Funding Rate, and the better the correction effect. Therefore, the price of the Perpetual Contract is "tamed" to be close to the spot price.
Funding Rate x Position Value = Funding Cost
The positive or negative Funding Rate determines which party needs to pay the Funding Cost. When the Funding Rate is positive, long positions pay the Funding Cost to short position holders, and when the Funding Rate is negative, short positions pay the Funding Cost to long position holders. In other words, when the contract is excessively overpriced, the Funding Rate is positive, and the buyer needs to pay the cost to the seller, and vice versa.
Traders only need to pay or receive Funding Costs if they hold positions at the Funding Cost settlement time. If they close the position before the Funding Cost settlement time, they will not pay or receive any Funding Cost.
The Funding Cost that traders pay will be deducted from their available margin. If there is not enough available margin, the Funding Cost will be deducted from their position margin. At this time, the liquidation price will gradually approach the reasonable price due to the deduction of the Funding Cost, thereby increasing the risk of liquidation.
Currently, most exchanges settle funding fees every 8 hours, which means there are 3 settlements per day. For example, WEEX VIP Exchange settles funding fees three times a day at 7:00, 15:00, and 23:00 (UTC+8).
However, there are exchanges with different settlement times, such as FTX, which settles funding fees every 2 hours. Binance also settles funding fees every 8 hours, but after the FTX crash in November last year, the funding fees for FTTUSDT and SOLUSDT contracts were changed to settle every 2 hours. The DEX platform, dYdX, settles funding fees every 1 hour.
It should be noted that funding fees are not fees charged by the exchange, but rather a payment between long and short positions. The exchange aims to use this mechanism to reduce the price difference between the contract market and the spot market, thereby bringing the price back to normal levels. This mechanism can also limit malicious manipulation of contract prices and prevent extreme market volatility.
How to check the funding rate?
The funding rate for each perpetual contract is displayed on the websites and apps of various exchanges. As shown in the following image, the WEEX exchange website displays the funding rate for the BTC/USDT perpetual contract, which is currently 0.02153272%, and the next funding settlement will be in 7 hours and 55 minutes.
In addition, data platforms such as Coinglass and Coinsoho provide real-time funding rates for major CEX and DEX platforms.
How is the funding rate calculated?
Taking WEEX as an example, the platform provides two types of perpetual contracts.
Funding rate = position value x funding rate
For USDT-based contracts, position value = position size (in coins) x fair market price
For example, Trader A holds a long position of 10 BTC in the BTCUSDT contract when the fair market price of BTCUSDT is 10,000 USDT and the funding rate is 0.01%.
Position value = 10 x 10,000 = 100,000 USDT
Funding rate = 100,000 x 0.01% = 10 USDT
Since the funding rate is positive, Trader A needs to pay 10 USDT as funding fees, while a short position with the same contract size will receive 10 USDT as funding fees.
For coin-based contracts, position value = position size (in contracts) x contract face value / fair market price
For example, Trader A holds a long position of 100 BTCUSD contracts (where 1 contract face value = 100 USD) when the fair market price of BTCUSD is 10,000 USD and the funding rate is 0.01%.
Position value = 100 x 100 / 10,000 = 1 BTC
Funding rate = 1 x 0.01% = 0.0001 BTC
Since the funding rate is positive, Trader A needs to pay 0.0001 BTC as funding fees, while a short position with the same contract size will receive 0.0001 BTC as funding fees.
As the formula shows, the funding rate is independent of the leverage used.
So how can we take advantage of the difference in funding rate? We will dive deeply into some arbitrage examples in the next release.
[To be continued...]
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