Original Title: Funding - earning 25-50% passive income per year with the cash/carry strategy?
Original author: The Black Swan
Original Translation: Deep Tide TechFlow
In the crypto perpetual contract market, price deviations often occur, and traders can profit from these pricing errors.
'Spot and Futures Arbitrage' (Cash and Carry Trade) is a classic profit strategy that allows traders to gain profits from the differences between perpetual contract prices and spot prices.
Funding rate arbitrage - earning 25%-50% passive income per year through spot and futures arbitrage strategy?
In the crypto perpetual contract market, price deviations often occur, and traders can profit from these pricing errors. 'Spot and Futures Arbitrage' is a classic strategy specifically targeting the differences between perpetual contract and spot prices, allowing traders to easily achieve profits.
Through this strategy, traders can perform arbitrage operations on centralized exchanges (CEX) and decentralized exchanges (DEX) without incurring high fees. Specifically, you can establish a spot long position on an asset while selling the corresponding futures derivative. When the overall market leans toward long (i.e., when the price premium is high), you can gain additional returns through the funding rate. If this sounds a bit complicated, don't worry, I will explain it to you in a way that is easy to understand (ELI5).
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 to which the perpetual contract price deviates from the spot market.
In simple terms, when the trading price of the perpetual swap contract is higher than the spot price (i.e., premium), the deviations on trading platforms such as Binance, Bybit, dYdX, or Hyperliquid will turn positive, and at this time, 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., discount), the deviation will turn negative, and at this time, short traders need to pay the funding rate to long traders.
What we need to do is basically mimic the way Ethena Labs operates: going long on ETH spot while shorting ETH perpetual contracts. But the difference is, we will operate it ourselves and choose the assets we are interested in (hint: it doesn’t have to be ETH).
If you don’t want to read the previous content, I will try to explain it in a simple way for you.
Assuming we take Ethereum as an example, we want to take a long position on ETH (preferably staked ETH).
We can take stETH (annual yield of 3.6%) as an example while shorting $ETH in the perpetual contract market (e.g., on Binance or Bybit).
When we simultaneously take equal amounts of ETH long and short positions, our portfolio is in a 'delta neutral' state. This means that regardless of how ETH's price fluctuates, we will not incur losses or profits due to price changes.
'Delta Neutral Strategy' is an investment method that avoids market price fluctuation risks by balancing long and short positions. For example, if I simultaneously open a long position of 1 ETH and a short position of 1 ETH at the same price, regardless of how the market price changes, the total value of my portfolio will not be affected (ignoring fees).
In this strategy, our earnings come from two parts: staking rewards from ETH and funding fee income.
The funding rate is a mechanism used to adjust the differences between perpetual contract prices and spot market prices. Its function is similar to the interest cost in spot margin trading, regulating the flow of funds between long and short sides to ensure that the price of perpetual contracts does not deviate from the spot market price.
The settlement method for the funding rate is as follows:
· The funding fee is the cost settled directly between buyers and sellers, usually settled at the end of each funding interval. Taking an 8-hour funding interval as an example, the funding fee is settled at 12:00 AM, 8:00 AM, and 4:00 PM UTC.
· On decentralized exchanges like dYdX and Hyperliquid, the funding fee is 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 bull markets, 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 positions are closed before the funding settlement, no funding fee will be incurred.
· If the trader's account balance is insufficient to pay the funding fee, the system will deduct it from the position margin, causing the liquidation price to be closer to the marked price, thereby increasing the liquidation risk.
Let's analyze the funding rate shown in the image. The funding rate calculation mechanisms used by different perpetual contract exchanges on various chains may vary slightly, but as a trader, you need to understand the time periods for funding fee payments/receipts and how the funding rate fluctuates over time. Below is the method for calculating the annualized return (APR) based on the funding rate in the image:
For Hyperliquid:
0.0540% * 3 = 0.162% (1-day APR)
0.162% * 365 = 59.3% (1-year APR)
It can be seen that Binance's funding rate is lower, with an annualized yield 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, yielding a difference in annualized returns of 59.3% and 31.2%, which is 28.1%. However, this strategy also carries some risks:
1. Funding rate volatility may cause the long funding fee on Binance to be higher than the short funding fee on Hyperliquid, resulting in losses.
2. Because the long position is not spot, you cannot earn staking rewards, which reduces overall returns.
But the advantage of this method is that using perpetual contracts for long and short operations can leverage, thereby improving capital efficiency. It is recommended to create an Excel spreadsheet 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 receive the funding fee. This is crucial because it provides the basis for designing a delta-neutral strategy that profits from the funding rate.
Spot and Futures Arbitrage
One of the simplest and most common strategies is 'Spot and Futures Arbitrage' (Cash and Carry Trade), which involves simultaneously buying the spot asset and selling the same quantity of perpetual contracts. For ETH, 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 approximately $3,700. To execute this strategy, traders need to complete buying and selling operations at the same price and quantity as much as possible to avoid 'unbalanced risk' (i.e., market fluctuations causing both sides' positions to not fully hedge).
The goal of this strategy is to achieve a 59% annualized return through the funding rate, whether the market price rises or falls. However, although this return looks very tempting, traders need to be aware that the funding rates of different exchanges and different assets may vary, which will affect the final returns.
Your daily funding fee earnings can be calculated using the following formula:
Funding fee earnings = Position value x Funding rate
Taking the current ETH funding rate of 0.0321% as an example, we calculate the daily yield:
· Daily funding fee earnings: 10 ETH x 3,700 = $37,000 x 0.0540% = $20, settled 3 times a day, totaling $60.
· Daily staking yield: 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.
Thus, the total daily yield is $60 + $3.7 = $63.7. For some, this might be a decent return, while for others, it might seem trivial.
However, this strategy also faces some risks and challenges:
The difficulty of opening long/short positions simultaneously: When viewing 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, and the perpetual contract price was $3,861, with a price difference of $9.
1. How should you operate? Try with a small amount of capital, and you will find it almost impossible to perfectly match long and short positions.
2. Should you go long first and wait for the price to rise before going short, or should you go short first and wait for the spot price to fall before buying? Or should you balance long and short positions by dollar-cost averaging (DCA, gradually buying or selling in stages)?
Trading fees: Opening and closing positions incur trading fees. If your holding time is less than 24 hours, the fees may lead to losses.
Low capital rebalancing risk: If your long and short positions are equal, but the market fluctuates significantly (for example, ETH doubles to $7,600), the short position will incur deep losses while the long position will profit significantly. In this case, it may lead to an imbalance in your account's net worth, and you may even be forced to close positions.
Liquidation risk: Depending on the amount of available funds in your trading account, if the short position encounters extreme market conditions (such as ETH price surging), it may trigger a liquidation.
Funding rate volatility: The funding rate fluctuates with market changes, which can directly affect your returns.
The difficulty of closing positions simultaneously: The challenges faced during closing positions are similar to those during opening positions, and it may not be possible to precisely 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 face losses. This is similar to the risks of smart contract vulnerabilities in DeFi.
Risk of operational errors: If you are unfamiliar with perpetual contracts, you need to be especially cautious. Mistakes in market order operations can lead to extreme price fluctuations, and you may transact at very poor prices. Additionally, opening or closing a position just requires a click of a button, and operational errors can significantly affect the trading outcome.
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.
We see you in the order book, anonymous friend.
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