Perpetual Futures and Funding Rates

If you want to be successful in any pursuit, the key is to think like the pros, and in crypto, this means — at least in part — understanding the way that quant traders view the market. This, in turn, requires a decent grasp of some of the fundamental structures of derivatives markets, and I covered quarterly futures in some depth when I explained basis trading and how to do it in an earlier post.

In that article, I also mentioned the fact that perpetual futures work differently, and now the time has come to cover this increasingly popular type of derivatives, along with the basic mechanism by which their price is kept close to the price of the underlying asset, namely funding rates. This also offers a different way to make money in a market-neutral way, so the topic at hand is far from something merely theoretical (even though I would say that it’s part of a basic theoretical understanding of the markets that every single trader should have). With that said, let’s dive right in.

First, we need to look at what perpetual futures contracts are. Quarterly futures, which I covered recently, are contracts which give a trader the obligation to buy or sell the underlying asset at the expiration date, which is — as the name implies — at the end of a quarter. This means that the price of a quarterly futures contract becomes the same as the price of the underlying asset at settlement, i.e. when the contract expires.

Perpetual futures, on the other hand, don’t have an expiration date at all. They function just like other futures contracts in that they enable traders to use leverage, but the main difference is that they never expire. This raises an interesting question: if perpetuals never settle, then what stops their price from deviating from the underlying asset price by a lot, especially when market sentiment is very bullish or bearish? If there were no way to prevent this, perpetuals would become unpredictable to the point of being practically useless, as there would be no reason why they would have to closely track the underlying asset (unlike futures that do expire, which eventually settle to the same price as the underlying, but are also kept close to it long before expiry by people doing basis trades).

This is where funding comes in: if you’ve ever traded perpetuals, you’ve seen a funding rate displayed somewhere on the trading page, often above or next to the chart. This is the mechanism by which the perpetuals price is kept close to the underlying: if the perps are trading above the spot price, then the funding rate is positive, and if they’re trading below spot, then it’s negative. A positive funding rate means that longs pay shorts, while a negative rate means that shorts pay longs, thus incentivizing traders to bring the price back to the spot price.

The funding rate is expressed as a percentage, and this percentage of the position size is paid in different intervals on different exchanges: most have funding every eight hours, but some have it every hour. To take a practical example: let’s say the funding rate for BTC perps on Binance is 0.01% and you’ve got an open long worth $50k: when the funding countdown reaches zero (i.e. every eight hours), 5$ will be deducted from your account. On the other hand, if you’ve got a short open with the same position size, you’ll receive $5.

This doesn’t seem much, as it’s only 0.03% per day, but funding rates can be ridiculously high when market sentiment looks very bullish, so that you can even pay close to 1% of your position size just for keeping it open one day. Of course, this doesn’t really matter if you nail a 10% move over a day or two, but it can put quite a dent in your account if you keep your position open for longer (and this is also the reason why no one uses perps to make long-term investments).

Apart from just knowing what it will cost you to keep a position open, funding rates can give you a ton of important and actionable info. Simply put: when funding is extremely positive, that means that there are a lot of overleveraged longs, and that means that a very volatile move to the downside is likely. In that situation, if the price starts dropping even by a little, it will trigger some long liquidations, which means that the price will drop even more due to the forced selling. This, in turn, causes more liquidations, and a liquidation cascade can quickly develop, washing out everyone that was overleveraged.

The same applies if funding is extremely negative, since that means that there are a lot of shorts open. In that case, a short squeeze becomes more likely — basically the opposite of what I described above, with the rise in price bringing short liquidations, and this forced buying liquidating even more shorts. While extreme funding rates can persist for surprisingly long, they still offer a valuable clue, with positive funding signalling weakness and negative funding increasing the probability of the price shooting higher.

Last but not least, it’s important to mention a quant trading strategy based on perps: when the funding is very high, you can buy the underlying asset and use it as collateral to short futures. This way, you’ll earn money not just from funding, but also from the difference in price once futures come back to the spot price.

To take an example: let’s say BTC is at $50,000, the perp contract is trading at $50,100 and funding is 0.2% per day. You buy 1 BTC and short 1 perp contract. Then, no matter where the price goes, you’ll make 0.2% on your initial investment — in this case $100 — in funding over 24 hours. Additionally, if the perp contract comes back to the spot price at the end of the 24 hour period and you close your position at that time (along with selling your BTC collateral), you will make $200 on your $50,000 investment, which is a 0.4% return or 146% APY — not a bad yield! Of course, this example makes a number of simplifications (for example, the returns from the price difference and the funding rate would limit each other since they co-vary, so in most cases it would be closer to a total of 0.2% unless you get really lucky and time it perfectly), but making it more concrete would require much more math than you’d probably like to see, and it would still not be perfectly applicable to any real world situation you’ll encounter due to the sheer number of variants. The bottom line is — when funding is high, you can make a profit this way, and it’s up to you to calculate how much it would be in any specific scenario.

Apart from this, you can also short perps on an exchange where the funding is high and long them on an exchange where funding is significantly lower: this can also bring great returns, but it’s so complex (in terms of how much collateral you need, whether you want to be completely delta-neutral etc.), that it would need to be covered in a separate article. That’s that for now; the key thing is that you understand how perps work and what drives their price close to the spot price, and you’ve also got all the basic info on how to profit from funding fees.