Original author: The Black Swan
Original translation: ShenChao TechFlow
In the cryptocurrency perpetual contract market, price deviations often occur, and traders can profit from these pricing errors.
"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 cash and carry trade strategy?
In the cryptocurrency perpetual contract market, price deviations often occur, and traders can profit from these pricing errors. "Cash and Carry Trade" is a classic strategy specifically targeting the differences between perpetual contracts and spot prices, enabling traders to easily achieve profits.
Through this strategy, traders can perform arbitrage operations across centralized exchanges (CEX) and decentralized exchanges (DEX) without incurring high fees. Specifically, you can establish a long position in the spot asset while selling corresponding futures derivatives. When the market overall leans towards long (i.e., the price premium is high), you can obtain additional income through the funding rate. If you find this a bit complex, don't worry, I will explain it to you 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 difference 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 perpetual swap contracts is higher than the spot price (i.e., premium), the deviations on platforms like Binance, Bybit, dYdX, or Hyperliquid become positive, at which point long traders need to pay the funding rate to short traders. Conversely, when the trading price of perpetual swap contracts is lower than the spot price (i.e., discount), the deviations become negative, at which point short traders need to pay the funding rate to long traders.
What we need to do is essentially mimic the operation method of Ethena Labs: go long on the spot ETH while shorting ETH perpetual contracts. But the difference is that we will operate it 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 in a simple way.
Assuming we take Ethereum as an example, we wish to take a long position on ETH (preferably staked ETH).
We can take stETH (annualized yield of 3.6%) as an example and short $ETH on the perpetual contract market (e.g., on Binance or Bybit).
When we simultaneously take equal amounts of long and short positions in ETH, our portfolio is in a "Delta Neutral" state. This means that regardless of how the price of ETH fluctuates, we will not incur losses or profits due to price changes.
"Delta Neutral Strategy" is an investment method that balances long and short positions to avoid the risk of market price fluctuations. For instance, if I simultaneously open a long position of 1 ETH and a short position of 1 ETH at the same price, then regardless of how the market price changes, the total value of my portfolio will not be affected (ignoring fees).
In this strategy, our returns come from two parts: staking rewards of ETH and funding rate income.
The funding rate is a mechanism used to adjust the difference between the prices of perpetual contracts and the spot market. Its role is similar 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 of both longs and shorts.
The settlement method of the funding rate is as follows:
The funding fee is a fee settled directly between the buyer and seller, usually settled at the end of each funding interval. For example, in an 8-hour funding interval, the funding fee is settled at midnight, 8 AM, and 4 PM UTC.
On decentralized exchanges like dYdX and Hyperliquid, the funding fee is settled hourly, while Binance and Bybit settle it 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 happens 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 funding fees. If positions are closed before funding settlement, no funding fees 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, which may cause the liquidation price to be closer to the mark price, thus increasing the liquidation risk.
Let's analyze the funding rate shown in the picture. The funding rate calculation mechanism used by perpetual contract exchanges across different chains may vary slightly, but as a trader, you need to understand the time frame for paying/receiving funding fees and how the funding rate fluctuates over time. Here is how to calculate the annualized return (APR) based on the funding rate in the picture:
For Hyperliquid:
0.0540% * 3 = 0.162% (1-day APR)
0.162% * 365 = 59.3% (1-year APR)
It can be seen that the funding rate on Binance is lower, with an annualized return of 31.2% (calculated in the same way). Additionally, there are arbitrage opportunities between Hyperliquid and Binance. You can go long on the ETH perpetual contract on Binance while simultaneously going short on the ETH perpetual contract on Hyperliquid, thus obtaining a difference in the annualized return of 59.3% and 31.2%, which is 28.1%. However, this strategy also carries some risks:
Fluctuations in the funding rate may lead to long funding fees on Binance being higher than short funding fees on Hyperliquid, resulting in losses.
Because long positions are not spot, you cannot earn staking rewards, which will reduce overall returns.
But the advantage of this method is that using perpetual contracts for long and short operations can leverage the funds, thus improving capital efficiency. It is advisable 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 will receive the funding fee. This is crucial because it provides the basis for designing a delta-neutral strategy to profit from the funding rate.
Cash and Carry Trade
One of the simplest and most common strategies is "Cash and Carry Trade," which involves simultaneously buying the spot asset and selling the same amount of perpetual contracts. For example, the trading strategy for ETH 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 risk" (i.e., market fluctuations causing both sides of the position to not fully hedge).
The goal of this strategy is to earn 59% annualized returns through the funding rate, regardless of whether the market price rises or falls. However, although this return looks very attractive, traders need to be aware that the funding rates on different exchanges and assets may vary, 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, let's 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.
Thus, the total daily income is $60 + $3.7 = $63.7. For some, this may be a decent income, while for others, it may seem insignificant.
However, this strategy also faces some risks and challenges:
The difficulty of opening long/short positions simultaneously: Viewing the spot price of ETH and the perpetual contract price 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.
What should you do? 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 the long and short positions by building positions in batches (DCA, that is, gradually 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 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 substantial losses while the long position may profit significantly. In this case, it may lead to an imbalance in your account equity, even leading to forced liquidation.
Liquidation risk: Depending on your available funds on the exchange, if a short position encounters extreme market conditions (e.g., ETH price skyrocketing), it may trigger liquidation.
Fluctuations in the funding rate: The funding rate fluctuates with market changes, which can directly affect your income.
The difficulty of closing positions simultaneously: The challenges faced when closing positions are similar to those when opening positions, and it may not be possible to precisely match long and short positions, resulting in additional costs or risks.
Centralized exchange risk: If there are issues with Binance or Bybit, such as bankruptcy or withdrawal restrictions, your funds may face losses. This is similar to the risk of smart contract vulnerabilities in DeFi.
Operational error risk: If you are not familiar with perpetual contracts, you need to be especially careful. Mistakes in market order operations can lead to extreme price fluctuations, and you may execute trades at very unfavorable prices. Additionally, opening or closing a position only requires the press of a button, and operational errors may significantly affect the trading outcome.
By the way, you can also study options trading. This method may be simpler and save you some costs :)
I just wanted to show you how to try Ethena Labs' trading strategy.
That's all for today's content.
We see the order book, anonymous friend.
