Author: The Black Swan
Compiled by: Deep Tide TechFlow
In the crypto perpetual contract market, price deviations often occur, and traders can profit from these price errors.
The 'Cash and Carry Trade' is a classic profit strategy that allows traders to profit from the difference between perpetual contract prices and spot prices.
Funding rate arbitrage - earn 25%-50% passive income annually through spot and futures arbitrage strategies?
In the crypto perpetual contract market, price deviations often occur, and traders can profit from these price errors. The 'Cash and Carry Trade' is a classic strategy specifically targeting the differences between perpetual contracts and spot prices, allowing traders to easily realize profits.
Through this strategy, traders can perform arbitrage operations at centralized exchanges (CEX) and decentralized exchanges (DEX) without incurring high fees. Specifically, you can establish a long position in the spot asset while selling the corresponding futures derivatives. When the overall market leans toward long positions (i.e., price premiums are high), you can earn additional income through funding rates. If you find this sounds a bit complicated, don't worry, I will explain it in an ELI5 (easy to understand) manner.
What is the funding rate?
The funding rate is a periodic fee that traders need to pay or receive based on the differences between perpetual contract prices and spot market prices. The size of this rate depends on the skew of the perpetual contract market and the degree of deviation of the perpetual contract price relative to the spot market.
In simple terms, when the trading price of the perpetual swap contract is higher than the spot price (i.e., at a premium), the deviations on trading platforms like Binance, Bybit, dYdX, or Hyperliquid will become positive, at which point long traders need to pay the funding rate to short traders. Conversely, when the trading price of the perpetual swap contract is lower than the spot price (i.e., at a discount), the deviation will become negative, and short traders need to pay the funding rate to long traders.
What we need to do is basically mimic Ethena Labs' approach: go long on ETH spot while shorting ETH perpetual contracts. However, the difference is that we will operate ourselves and choose the assets we are interested in (hint: it doesn't have to be ETH).
If you do not want to read the previous content, I will try to explain it to you in simple terms.
Assuming we take Ethereum as an example, we want to take a long position in ETH (preferably staked ETH).
We can take stETH (annualized return of 3.6%) as an example, while simultaneously shorting $ETH in the perpetual contract market (for example, on Binance or Bybit).
When we simultaneously take equal long and short positions in ETH, our portfolio is in a 'Delta Neutral' state. This means we will not incur losses or profits due to price changes, regardless of how ETH's price fluctuates.
The 'Delta Neutral Strategy' is an investment method that balances long and short positions to avoid risks from market price fluctuations. For example, if I simultaneously open a long position of 1 ETH and a short position of 1 ETH at the same price, my portfolio's total value will not be affected by changes in market prices (ignoring fees).
In this strategy, our income comes from two parts: staking income from ETH and funding rate income.
The funding rate is a mechanism used to adjust the difference between perpetual contract prices and spot market prices. It functions similarly to the interest cost in spot margin trading, ensuring that the price of perpetual contracts does not deviate from the spot market price by adjusting the capital flow between long and short positions.
The settlement method for the funding rate is as follows:
The funding fee is the fee settled directly between buyers and sellers, usually settled at the end of each funding interval. For example, with an 8-hour funding interval, the funding fee is settled at 12 AM, 8 AM, and 4 PM UTC.
On decentralized exchanges such as dYdX and Hyperliquid, funding fees are settled hourly, while Binance and Bybit settle every 8 hours.
When the funding rate is positive, long position holders pay the funding fee to short position holders; when the funding rate is negative, short position holders pay the funding fee to long position holders (this usually occurs in a bull market, which I will explain in detail later).
Only traders who hold positions at the time of funding settlement will pay or receive the funding fee. If they close their position before the funding settlement, no funding fee will be incurred.
If a trader's account balance is insufficient to pay the funding fee, the system will deduct it from the position margin, which will bring the liquidation price closer to the mark price, thus increasing liquidation risk.
Let's analyze the funding rates shown in the image. The funding rate calculation mechanisms used by perpetual contract exchanges on different chains may vary slightly, but as a trader, you need to understand the time periods for paying/receiving funding fees and how funding rates fluctuate over time. Here’s how to calculate the annualized return (APR) based on the funding rates in the image:
For Hyperliquid:
0.0540% * 3 = 0.162% (1 day APR)
0.162% * 365 = 59.3% (1 year APR)
As you can see, Binance's funding rate is relatively low, with an annualized return of 31.2% (calculated in the same way). Additionally, there is an arbitrage opportunity between Hyperliquid and Binance. You can go long on ETH perpetual contracts on Binance while shorting ETH perpetual contracts on Hyperliquid, thus obtaining a differential annualized return of 59.3% and 31.2%, or 28.1%. However, this strategy also carries some risks:
Funding rate fluctuations may cause the long funding fee on Binance to be higher than the short funding fee on Hyperliquid, leading to losses.
Because long positions are not spot, you cannot receive staking rewards, which will lower the overall returns.
But the advantage of this method is that when using perpetual contracts for long and short operations, you can leverage to improve capital efficiency. It is recommended to create an Excel sheet to compare the returns and risks of different strategies to find the one that suits you best.
When the funding rate is positive (as shown in our example), long traders need to pay the funding fee, while short traders will receive the funding fee. This is crucial because it provides the basis for designing a Delta neutral strategy to profit from funding rates.
Spot and futures arbitrage
One of the simplest and most common strategies is the 'Cash and Carry Trade', which involves simultaneously buying spot assets and selling perpetual contracts in the same quantity. Taking ETH as an example, the trading strategy is as follows:
Buy 10 ETH/stETH spot (worth $37,000)
Sell 10 ETH perpetual contracts (worth $37,000, operable on dYdX, Hyperliquid, Binance, or Bybit)
At the time of writing this article, the trading price of ETH is about $3,700. To execute this strategy, traders need to complete buy and sell operations simultaneously at the same price and quantity to avoid 'unbalanced risks' (i.e., market fluctuations leading to positions that cannot be fully hedged).
The goal of this strategy is to achieve 59% annualized returns through funding rates, whether the market price goes up or down. However, while this return looks very attractive, traders need to be aware that funding rates may vary across different exchanges and different assets, which will affect the final returns.
Your daily funding fee income can be calculated using the following formula:
Funding fee income = Position value x Funding rate
Taking the current funding rate of ETH at 0.0321% as an example, we calculate the daily income:
Daily funding fee income: 10 ETH x 3,700 = $37,000 x 0.0540% = $20, settled 3 times a day, totaling $60.
Daily staking income: 10 ETH x 1.036 = 0.36 ETH per year / 365 = 0.001 ETH per day, equivalent to $3,700 x 0.001 ETH = $3.7.
Therefore, the total daily income is $60 + $3.7 = $63.7. For some, this may be a nice income, while for others, it may seem trivial.
However, this strategy also faces some risks and challenges:
The difficulty of opening long/short positions simultaneously: When you check the spot price and perpetual contract price of ETH on Binance or Bybit, you will find that there is usually a price difference between the two.
For example, when I wrote this article, the spot price was $3,852, while the perpetual contract price was $3,861, with a price difference of $9.
How should you operate? Try with a small amount of funds; you will find it almost impossible to perfectly match long and short positions.
Should you go long first and wait for the price to rise before going short, or go short first and wait for the spot price to fall before buying? Or balance long and short positions by gradually building positions (DCA, which means buying or selling in stages)?
Trading fees: Opening and closing positions incur fees. If your holding period is less than 24 hours, the fees may cause you to incur losses.
Low capital rebalancing risk: If your long and short positions are equal, but the market fluctuates significantly (e.g., ETH doubles to $7,600), the short position may incur deep losses while the long position profits significantly. In this case, it may lead to an imbalance in your account equity, even forcing liquidation.
Liquidation risk: Depending on the amount of available funds in your exchange account, if the short position encounters extreme market conditions (e.g., ETH price surges), it may trigger liquidation.
Funding rate fluctuations: The funding rate will fluctuate with market changes, which may directly affect your income.
The difficulty of closing positions simultaneously: The challenges faced when closing positions are similar to those when opening them, and it may not be possible to accurately match long and short positions, leading to additional costs or risks.
Centralized exchange risk: If Binance or Bybit encounters issues, such as bankruptcy or withdrawal restrictions, your funds may be at risk. This is similar to the risk of smart contract vulnerabilities in DeFi.
Operational error risk: If you are unfamiliar with perpetual contracts, you need to be particularly careful. Mistakes in market order operations may lead to extreme price fluctuations, and you may execute trades at very poor prices. Additionally, opening or closing a position only requires pressing a button, and operational errors may significantly affect trading results.
By the way, you can also study options trading. This method may be simpler and can save you some costs :)
I just want to show you how to try Ethena Labs' trading strategy.
That's all for today's content.
We see the order book, anonymous friend.
