《Trading Notes》——What is the funding rate?

Funding rate is the cost of holding an open position in a perpetual swap (PERP).

It is usually calculated from the difference between the [perpetual contract price] and the [spot benchmark index price].

If funds are positive, the perpetual contract price is trading at a premium (higher) than the index price. Opening a long position pays funds, opening a short position receives funds.

If funds are negative, the perpetual contract price is trading at a discount (below) the index price. Opening a short position pays funds, opening a long position receives funds.

Unlike standard futures contracts, perpetual contracts have no expiration or rollover mechanism.

This begs the question: Why do perpetual contracts generally align with the spot market?

Answer: Funding rate.

This is a built-in arbitrage mechanism designed to incentivize traders to keep these instruments (specifically their prices) aligned.

For example: Perpetual contract trading is much higher than the spot index price --> Funding rate increases.

Two things can happen:

1. It becomes more expensive to hold long positions (negative incentive).

2. Traders can buy spot, sell perpetual contracts, and collect funding rates with minimal directional risk (positive incentive).

The greater the difference between the perpetual contract price and the spot price, the higher the funding rate.

Think of it as a way to provide greater arbitrage incentives when these instruments become disconnected from each other.

To make it clear, funding is primarily generated by the difference between the perpetual contract price and the spot-based index price.

I would also like to reiterate an important point made earlier: if funds are at baseline levels or there are no interesting divergences between price, funds, and time, then you are unlikely to find attractive trade setups.

All of these tools become complementary and contextually interesting tools when “something doesn’t make sense” or when they are at relative extremes.

From a trading perspective, identifying divergences between funding and price can bring you one step closer to generating productive trading ideas:

1. Example: High positive funding rate, but falling or stagnant/not rising prices.

1.1. Reasonable inference: Perpetual longs are active but not rewarded. This could be bearish (especially if other situational clues are present, such as price entering a key resistance level).

2. Example: High negative funding rate, but rising or stagnant/not falling prices.

2.1. Reasonable inference: Perpetual shorts are active but not rewarded. This could be bullish (especially if other situational clues are present, such as price entering key support levels).

3. Example: Funding becomes more positive when prices fall.

3.1. Reasonable inference: Perpetual contract buying is counter-trend in "distrust", fading the downward momentum, and/or spot traders are active sellers. This may be bearish (especially if other situational clues are present, such as rising perpetual contract open interest, spot volume and CVD leading, etc.).

4. Example: Funding becomes more negative as prices rise.

4.1. Reasonable inference: Perpetual contract selling is counter-trend in "distrust", fading upward momentum, and/or spot traders are active buyers. This may be bullish (especially if other situational clues are present, such as rising perpetual contract open interest, spot volume and CVD leading, etc.).

These are just some basic examples and you can construct many more trade setups, especially combining OI + CVD under the right circumstances.

Essentially, we are back to very important first principles here:

1. Who (if anyone) is active?

2. Are they rewarded for their initiative?

Finally, it is important to understand not only funding rates and their impact, but also how they are generated.

I can think of three situations where funding rates are most commonly misinterpreted.

1. Negative funding rates after huge fluctuations and forced liquidations.

As mentioned earlier, funding reflects the difference between the perpetual contract price and the index price.

Perpetual contracts are more highly leveraged than the spot assets that typically make up the index. Therefore, when there are large liquidations in perpetual contracts, these liquidations and chaotic unwinding can amplify the size of the move.

In extreme cases, perpetual contracts will often be more out of touch than spot, so they will be priced at a discount.

Therefore, negative funding after the wipeout period does not necessarily mean that the market is short from the bottom. It is just a reflection that the perpetual contract has suffered a greater blow than spot due to the leverage provided.

hit.

2. “Backwardation”.

Backwardation — a situation where the spot price of an asset remains consistently higher compared to the perpetual contract or futures price — can provide useful signals.

For example, during the 2021 bull run, we often saw that prices on spot exchanges such as Coinbase were consistently higher than perpetual contracts and futures during U.S. trading hours.

To some extent, this can be seen as a reflection of risk appetite and more aggressive buyers in the spot market, which is generally a good sign.

However, the same argument has been made many times when falling from circa ~50k BTC, but to lesser effect.

Mechanically, spot leads the selling --> perpetual follows --> perpetual moves more aggressively due to forced liquidations and more aggressive declines --> perpetual ends up below spot --> “backwardation”.

This is the same backwardation in form, but completely different in substance and context.

If you use backwardation as an argument for spot demand, make sure you have other arguments that show there is demand in the market (not just funding rates or basis).

3. Unreliable abnormal currency (max) funding rate = squeeze may occur in the near future.

Especially in the second half of 2023, this is a very relevant pattern.

It goes something like this: huge price rally --> very negative funding rates --> speculators tend to go long/keep squeezing based on negative funding rates to get more upside --> however, in reality spot falls sharply, and then funding rates return to normal.

Especially for the outlier small cap coins, I would be skeptical about looking too closely at the funding side of things, as it can often be more “manipulated.” The signals will often be clearer on more liquid, larger market cap assets.

More broadly, relying on funding rates alone is not always a strong squeeze argument.

You need to first build an initial credible case that the attacker was at fault, preferably with some multiplicity combined with OI.

Even so, positive funding rates can normalize via perpetual contract closes/spot buys, and negative funding rates can normalize via perpetual contract buys/spot sells - without any dramatic squeezes.