When it comes to crypto derivatives, there are some definitive terms you must get acquainted with in order to trade successfully. Funding rates are one primary aspect in trading on derivative markets, as they determine how much traders must trade to keep their positions open.
Usually, standard crypto futures contracts settle monthly or quarterly, but perpetual contracts don’t have an expiry time. For example, a trader can hold a long/short position for as long as they want, except when the position gets liquidated.
However, since perpetual futures contracts don’t settle conventionally, crypto futures exchange platforms need a framework to ensure that futures prices and index prices converge regularly. This framework is described as a funding rate.
What Are the Funding Rates?
Simply put, funding rates are the fees traders pay to another set of traders who have taken a position opposite to theirs. These fees are typically estimated hourly or eight-hourly and are expressed as a percentage of the contract’s notional value.
In other words, we can describe these rates as periodic payments paid by one side of a perpetual futures contract to the other. It is also important to note that the exchange platform does not charge funding rates.
How are Funding Rates Calculated?
A funding rate is calculated based on the difference between the current price of the futures contract and the underlying asset’s spot price. If the futures contract is trading at a premium to the spot price, then traders who are long on Crypto futures will have to pay a higher funding rate. Conversely, if the futures contract is trading at a discount to the spot price, then traders who are short on Bitcoin futures will have to pay a higher funding rate.
Notably, funding rates are impacted by the amount of leverage traders use. Leverage is the amount of money you borrow to trade on a particular asset. The more leverage you use, the higher the funding rate will be. This is because the risk of the position is higher when you use more leverage, and traders who are short on Bitcoin futures for example, will demand a higher fee to compensate for the increased risk.
Funding rates are not static and can fluctuate rapidly based on market conditions. In fact, funding rates can sometimes be very high, which can make trading on futures exchanges expensive. This is why it’s essential to keep an eye on the funding rates when trading on derivative markets.
Interpreting Funding Rates
Funding rates can be an indicator of market sentiment on derivatives exchanges, such as futures exchanges.
When the funding rate is high, it can indicate that there is a strong bullish sentiment in the market, meaning that traders who are long on a certain crypto asset are willing to pay a high fee to maintain their trading positions.
In contrast, a low or negative funding rate can show a bearish sentiment in the market, meaning that traders who are short on a particular asset are willing to pay a fee to maintain their positions, reflecting confidence in further price decrease of the cryptocurrency.
How Does the Funding Rate Affect Traders?
Funding Rates can have a significant impact on a trader’s profits and losses, mainly because they consider the amount of leverage used. When a trader has high leverage and has to pay for funding, they may suffer losses and face liquidation, even in low-volatility markets. It can be rather challenging for such traders.
Alternatively, collecting funding can be very profitable, in particular when markets are range-bound. Traders can make use of this information and develop trading strategies to take advantage of the Funding Rates which would make profit even in low-volatility markets.
In essence, Funding Rates are designed to encourage traders to take positions that keep perpetual contract prices in line with spot markets. By doing this, traders can ensure that the prices of the contracts track the prices of the underlying assets closely.
Overall, Funding Rates are periodic payments paid to traders on both long and short terms in reflection of the difference between perpetual contract markets and spot prices. It is essential to note that these rates can fluctuate erratically based on market conditions, so it’s vital to monitor funding rates continuously when trading.
Disclaimer: The opinions expressed in this blog are solely those of the writer and not of this platform.