Funding Rate: Cost Of Perpetual Futures In Crypto

In the fast-paced world of crypto derivatives, understanding every mechanism is crucial for success. Among the most critical yet often misunderstood concepts is the funding rate, a unique feature of perpetual futures that directly impacts your trading costs and profits.

The funding rate is a regular payment exchanged between long and short position holders in a perpetual futures contract. Its primary purpose is to keep the perpetual contract's price closely aligned with the underlying asset's spot price, preventing large and sustained deviations.

Why it matters

• Cost of Carry: Directly impacts the profitability of holding perpetual futures positions over time.

• Market Sentiment Indicator: A positive funding rate often signals bullish sentiment, while a negative rate suggests bearishness.

• Arbitrage Opportunities: Creates opportunities for traders to profit from price discrepancies between perpetual futures and spot markets.

• Risk Management: Essential for traders to factor into their risk assessment and position sizing.

• Liquidity Provision: Encourages market makers to provide liquidity by incentivizing them to balance long and short exposure.

How it works

1. Price Discrepancy: When the perpetual futures price deviates from the spot price, a premium or discount emerges.

2. Funding Rate Calculation: Exchanges calculate the funding rate based on the difference between the perpetual contract's price and the spot price, often using an index price.

3. Payment Mechanism: If the perpetual price is higher than the spot price (positive funding rate), longs pay shorts. If the perpetual price is lower (negative funding rate), shorts pay longs.

4. Periodic Exchange: These payments occur at fixed intervals, typically every 8 hours, directly between traders without involving the exchange as a counterparty.

5. Price Convergence: The act of paying or receiving funding incentivizes traders to open positions that push the perpetual price back towards the spot price.

Example with realistic numbers

Consider a Bitcoin (BTC) perpetual futures contract on an exchange. The current BTC spot price is $60,000. Due to strong bullish sentiment, the BTC perpetual futures contract is trading at $60,100. The exchange calculates a positive funding rate of +0.01% for the next 8-hour interval.

• Long Position Holder: A trader holding a $10,000 long position will pay $10,000 * 0.0001 = $1.00 to short position holders.

• Short Position Holder: A trader holding a $10,000 short position will receive $1.00 from long position holders.

This payment incentivizes more traders to open short positions or close long positions, pushing the perpetual price down towards the spot price, and vice-versa if the funding rate were negative.

Common mistakes

• Ignoring Funding Costs: Underestimating the cumulative impact of funding payments on long-term position profitability.

• Misinterpreting Rate Direction: Assuming a positive rate always means the market will go up, or a negative rate means it will go down, without considering other factors.

• Not Adjusting Strategy: Failing to adapt trading strategies based on significant or sustained funding rate changes.

• Overleveraging: High leverage amplifies funding costs, potentially leading to faster liquidations during adverse funding periods.

Quick checklist

• Understand how funding rates are calculated on your chosen exchange,e.g. a leading crypto exchange Bybit.

• Monitor funding rates for your open positions regularly.

• Factor funding costs into your trade entry and exit strategies.

• Consider funding rate trends as a market sentiment indicator.

• Be aware of how leverage impacts your funding obligations.

• Explore strategies like basis trading to potentially profit from funding rate differentials.

Related terms

• Perpetual Futures

• Spot Price

• Index Price

• Basis Trading

• Derivatives

• Leverage

FAQs

Q: What is a positive funding rate?

A: A positive funding rate means that traders holding long positions pay traders holding short positions. This typically occurs when the perpetual futures price is trading above the spot price.

Q: What is a negative funding rate?

A: A negative funding rate means that traders holding short positions pay traders holding long positions. This usually happens when the perpetual futures price is trading below the spot price.

Q: How often are funding rates paid?

A: Funding rates are typically exchanged every 8 hours, though the exact interval can vary by exchange.

Q: Who pays the funding rate?

A: The side of the market (longs or shorts) that is driving the perpetual contract's price away from the spot price pays the other side.

Q: Can funding rates be used as a trading indicator?

A: Yes, funding rates can serve as a sentiment indicator. Consistently positive rates may suggest bullish sentiment, while consistently negative rates may indicate bearish sentiment.

Q: Do all crypto exchanges have funding rates?

A: Funding rates are a feature of perpetual futures contracts, which are offered by many, but not all, crypto derivatives exchanges. Spot trading does not involve funding rates.