The Ultimate Guide - Funding Rates Explained & Funding Rate Trading Strategy 🏮
What is the Funding Rate?
In this section, the speaker introduces the concept of the funding rate and highlights that many people do not fully understand its meaning.
Understanding the Funding Rate
- The funding rate can be seen as the cost to hold a position in trading.
- It is often compared to an interest rate, but there is another important component that provides an edge in trading.
- The funding rate represents the cost one trader pays to hold their position, while the other side receives a funding fee.
- Contrary to popular belief, whether longs or shorts pay the fees does not depend on market imbalance but rather on each individual trade.
Explaining Holding Positions and Trades
This section delves into holding positions and trades and clarifies how one side pays the funding fee while the other receives it.
Holding Positions and Trades
- When taking a trade, such as buying Ethereum or Bitcoin, one enters a position.
- In futures and options markets, there are always two sides to a trade - a long side and an equal short side.
- Only one side pays the funding rate (funding fee), while the other receives it.
- For example, if you are in a long position and paying the funding rate, someone who has taken a short position will receive that funding fee.
Why Does the Funding Rate Exist?
This section explores why the funding rate exists specifically in perpetual futures contracts.
Purpose of Funding Rate
- The funding rate is specific to perpetual futures contracts.
- Unlike spot markets or normal futures markets where no funding fee is paid, perpetual futures contracts involve paying or receiving a funding fee.
- Buying cryptocurrencies on spot markets or traditional futures involves a premium or discount, not a funding fee.
Understanding Futures Trading Platforms
This section briefly introduces futures trading platforms and assures viewers that understanding them is simpler than it may seem.
Futures Trading Platforms
- Various futures trading platforms, such as Derbit or Binance, operate on similar concepts.
- These platforms display information like flashing numbers and terms like contango or backwardation.
- While it may initially appear complicated, understanding these concepts becomes easier with time.
- The speaker promises to explain these terms in simplified videos and also mentions an upcoming series on FTX.
Timestamps for the remaining part of the transcript are not provided.
New Section
In this section, the speaker explains how to select futures contracts on the Deribit trading platform and discusses the differences between perpetual contracts and normal future contracts.
Selecting Futures Contracts
- Use the drop-down menu to choose a futures contract with a specific expiration date.
- Perpetual contracts never expire, while normal future contracts have an expiration date.
- The selected contract's price is displayed, which may differ from the perpetual price.
Differences Between Perpetual and Normal Future Contracts
- Perpetual contracts do not have funding fees, unlike normal future contracts.
- The prices of futures contracts expiring in the future can be different from the perpetual price.
- The term "backwardation" refers to when futures trade at a discount to the spot market, while "contango" refers to trading at a premium.
- Backwardation and contango will be explained in more detail in a separate video.
New Section
This section explores how futures markets can trade at either a premium or a discount compared to the spot market. It introduces backwardation and contango as terms used to describe these situations.
Price Differences in Futures Market
- Futures market prices can be higher (premium) or lower (discount) than spot market prices.
- Backwardation refers to trading at a discount, while contango refers to trading at a premium.
- Understanding these concepts can help identify potential profitable trades.
New Section
This section highlights both advantages and inconveniences of using futures contracts. It specifically addresses rollover risk faced by trend traders.
Advantages and Inconveniences of Futures Contracts
- Futures contracts are useful for businesses looking to hedge against losses or opportunity costs.
- However, they come with inconveniences, such as rollover risk for trend traders.
- Rollover risk occurs when a trader needs to switch to a new futures contract as the current one approaches expiration.
- Trend traders may have to pay premiums repeatedly during rollovers, resulting in potential losses.
New Section
This section further explains rollover risk and its impact on trend traders. It discusses the process of buying at a premium, selling at parity with spot prices, and buying at a premium again during rollovers.
Rollover Risk for Trend Traders
- Trend traders aim to enter positions at a premium compared to spot prices.
- As contracts approach expiration, the premium collapses to spot price levels.
- Traders must then roll over their positions to new contracts, potentially at higher premiums.
- This process of buying at a premium, selling at parity with spot prices, and buying at a premium again leads to potential losses due to the difference in premiums.
The transcript provided does not include any timestamps beyond 756 seconds.
Understanding the Difference Between Expiring Contracts and Perpetual Contracts
In this section, the speaker discusses the difference between expiring contracts and perpetual contracts in trading.
Expiring Contracts vs. Perpetual Contracts
- Expiring contracts, such as those expiring on November 26th, are trading at parity with perpetual contracts.
- If a trader is in a profitable trade using an expiring contract, they would need to roll over their position by selling the current contract and buying a future month expiration contract.
- However, rolling over contracts may result in paying a premium again when buying the future month contract.
- This can eat into long-term profits for trend traders who want to hold onto their positions.
Advantages of Perpetual Contracts
In this section, the speaker explains the advantages of trading perpetual contracts compared to normal futures contracts.
No Expiration and Funding Rate
- Perpetual contracts do not have an expiration date and trade continuously without needing to be rolled over.
- They are designed to closely track the spot market price.
- Unlike normal futures contracts that may have a premium or discount, perpetual contracts have a funding rate.
- The funding rate indicates whether longs or shorts pay each other based on market conditions.
Understanding Funding Rate Determination
In this section, the speaker discusses how funding rates are determined for perpetual contracts.
Role of Funding Rate
- The funding rate determines who pays whom in perpetual contract trading.
- It is not influenced by the number of longs or shorts in the market.
- The platform sets incentives through funding rates to keep prices close to the spot price.
- If prices drift away from the spot price, incentives are provided to push the price back towards it.
Perpetual Contracts and Spot Price Tracking
In this section, the speaker explains how perpetual contracts track the spot price.
Parity with Spot Price
- Perpetual contracts are designed to track the spot price as closely as possible.
- Due to leverage and aggressive trading, prices may drift away from the spot market.
- However, platforms incentivize traders through funding rates to bring prices back towards the spot price.
Summary of Perpetual Contracts
In this section, the speaker provides a summary of perpetual contracts and their advantages.
Key Points
- Perpetual contracts trade continuously without expiration.
- They aim to closely track the spot market price.
- Funding rates determine who pays whom in perpetual contract trading.
- Incentives are provided through funding rates to keep prices close to the spot price.
New Section
This section discusses the incentives and behavior of longs and shorts in relation to the funding rate.
Incentives of Longs and Shorts
- Longs pay money to hold on to their position, while shorts get paid to hold on to their position.
- The funding rate affects the incentives of both longs and shorts.
- When the funding rate is high, longs may close out their positions, leading to selling pressure and a decrease in price.
- Shorts are incentivized to put on new positions when they are getting paid, causing more selling pressure.
- When the price goes below a certain level, longs start getting paid and shorts have an incentive to close out or not put on more positions. This can lead to buying pressure and an increase in price.
New Section
This section explains how the funding rate acts as a balancing mechanism for market participants.
Role of Funding Rate
- The funding rate acts as a disincentive or incentive for market participants to push the price back towards the spot price.
- When the market trades above the spot price, longs pay shorts, not because there are more longs than shorts, but because of the aggressiveness of long orders. Leverage allows them to express their bullishness on the market.
- The funding rate helps keep aggressiveness in check and ensures that the price stays close to the spot price.
New Section
This section discusses how traders can use the funding rate to make more informed trading decisions.
Using the Funding Rate
- The funding rate provides insights into the current sentiment and behavior of market participants. It can add an edge to trading strategies when combined with other indicators.
- Combining the funding rate with other indicators and strategies can give traders additional confidence in their trades. However, it is not recommended to use the funding rate as the sole basis for counter-trading sentiment.
New Section
This section discusses how traders can use the funding rate to make more informed trading decisions.
Using the Funding Rate
- The funding rate provides insights into the current sentiment and behavior of market participants. It can add an edge to trading strategies when combined with other indicators.
- Combining the funding rate with other indicators and strategies can give traders additional confidence in their trades. However, it is not recommended to use the funding rate as the sole basis for counter-trading sentiment.
New Section
This section discusses the relationship between the market direction and funding rate, highlighting scenarios of confluence and divergence.
Understanding Market Direction and Funding Rate
- When the market is trending downwards but the funding rate is consistently positive, it indicates a divergence between aggressive long positions and the market movement. Longs may face pressure to exit their losing positions.
- Conversely, if the price is trending upwards while funding is negative, short positions may feel pressure to close their positions. This can lead to an impulsive move towards the upside.
- An example of this scenario occurred with a trade on Shiba Inu where aggressive negative funding led to holding onto a position for additional gains.
New Section
This section explains how to take advantage of the funding rate by capturing only the funds received without having exposure to the asset's direction.
The Funding Rate Trade Strategy
- When the funding rate is positive, indicating longs paying shorts, you can execute a strategy that involves going long on a spot exchange (e.g., Coinbase) and simultaneously taking an equivalent short position on a perpetual exchange (e.g., Deribit).
- These offsetting positions allow you to receive funding rate fees while being neutral on the asset's direction. However, there are opportunity costs and counterparty risks associated with this trade.
New Section
This section emphasizes the importance of learning and understanding key concepts rather than seeking quick results. It also encourages viewers to join their Discord community for further learning opportunities.
Importance of Learning and Joining the Community
- Those who seek to learn and understand important concepts are rare, and it is commendable to be part of this minority.
- Viewers are invited to join the Discord community for a collaborative learning journey.
New Section
This section provides a summary of the topics covered in the video.
Summary of Topics Covered
- The video discussed the funding rate, its purpose, and how it can be utilized in trading strategies.
New Section
This section discusses the design of the perpetual futures contract and how it trades closely to the spot price through the funding rate. It also explores three strategies to take advantage of the funding rate in trading.
Strategies for Trading with Funding Rate
- Using the funding rate as a simple vanilla counter sentiment trading strategy.
- Incorporating the funding rate with trend analysis to identify confluence or divergence.
- Implementing a market direction neutral strategy to capture profits solely from the funding rate.
New Section
This section explains how traders can capture the funding rate by taking a neutral position and participating in the funding rate incentive mechanism.
Capturing Funding Rate
- Traders put on a short position on the perpetual exchange while simultaneously taking a long position on the spot exchange.
- The downward pressure on perpetual contracts incentivizes them to trade closer to spot prices.
New Section
The final section concludes the video, encouraging viewers to provide feedback if they found it informative and enjoyable.
Conclusion
- Viewers are encouraged to like and comment if they found the video informative and enjoyable.