EP4 - What is funding rate?

Funding rates

One of the most misunderstood market concepts in crypto and all of CT when it is really
not that complicated. There’s a very big misconception and “simplified” explanation that
CT tries to use to define funding rates when it is completely wrong.

Most of you likely think that funding rate works like RSI and shows whether a coin is
heavily longed or heavily sold which is far from the truth.

Positive funding rate DOES NOT EQUAL a very overbought asset

Negative funding rate DOES NOT EQUAL a very oversold asset

If you want a simple definition on how funding rate works is that:

A negative funding rate means that shorts pay longs.

A postive funding rate means that longs pay shorts.

The funding rate is an attempt to incentivise traders to trade

against the trend in order to provide liquidity. You either pay or
receive interest every 8 hours.

Now that we debunked a few common myths and outlined a basic baseline definition to
work with, we can get into the more complicated bits into how funding rate works.

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 How is the funding rate calculated?

I will be using @IDrawCharts explanation to help explain this because he’s done a
fantastic job in breaking it down in simple terms for people to understand.
The funding rate on most exchanges is determined by taking the average difference
between the perp price and spot asset price over n as a percent, multiplied by n / 24,
where n is the number of hours per funding period. Sometimes there is an additional
default funding rate.
What this means is that over 24 hours, longs or shorts have to pay their
counterparties the cost of the average premium or discount of the contract. This
ensures that the contract stays roughly aligned with spot price. (Premium = perp price >
spot price), (Discount = perp price < spot price)

What do you actually pay in funding?

The funding you pay or receive:

Funding = position size * funding rate

Traders should always be aware of what the funding rate is because at certain times it
can be dangerous to remain/take a position.
For example, if the funding rate was 2%, and you were long with a 50x leverage position
and you were still at BE or even in slight loss, when the funding rate payment occurs,
your position will be liquidated. This is because you are unable to afford to keep the
position open.
A good analogy of defining what funding rate is to think of it as ‘rent’ and you have to
pay rent every 8 hours to continue keeping your position open. Since there’s this
dynamic of funding payment being taken every 8 hours, when this takes place, there’s
usually some ‘funky’/abnormal PA around this time because traders will close or take
positions very near it in order to either capitalise on the funding rate or avoid paying it.

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 So how is this useful?

Funding rate can also be seem as ‘passive income’ because if you have a long position
huge in profit for example and funding rate was negative -1%, you will be paid 1% every

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 8 hours for having the position open and vice versa. This opens up the possibility of
funding rate being ‘gamed’. What I mean by this is that PA starts to get a bit ‘funky’
when nearing the window of the funding rate payment.
For example, if there was a -1% funding rate payment due on AVAXUSDTPERP in 5
minutes, you will start to see erratic PA. This is because traders who were short may
close their positions because they do not want to pay this funding rate payment.
Likewise, there were will be traders who will wait until the very last few minutes of the
funding rate payment to open long positions in order to capture this 1% funding
rate payment.

However, since majority of sharp traders are aware of the fact others are trying to
‘game’ this funding rate payment, you will often see that if there was an -x% funding
rate, price will dump by at least x% to make the funding rate payment cancel out/may
dump even more than it actually was.

You should be aware of these little market dynamics as it will help you be more efficient
in taking profits and not roundtripping/getting wicked out during these funding round
payments if your stops are too tight.

How do we use funding rate to trade?

Using ‘funding rate’ to make a trade is pretty arbitrary as its more used as a
confluencing factor in your complete trading thesis hence why I deprioritised this
concept to be in EP4. However, it is a good litmus for determining when coins are close
to topping if they have an insanely negative funding rate. For example, you may have
seen sometimes funding rate caps to be lifted as the spot vs perp spread has blown out
so much that Binance have to increase how negative funding rates can be in order to
normalise the spread.
When this happens and this phenomenom often occurs when funding rate reaches -1%
or even -2% if the funding rate cap has been increased, coins tend to ‘top’ out. We can
speculate a lot on why this actually occurs and dive deeper into market microstructure,
psychology, market dynamics etc. but for most trading purposes you just need to be
aware that this occurs so its often a good point to start TPing your positions if you
managed to ride the short squeeze that caused this funding rate to occur.

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 On the flip side, you can also use funding rates to ‘know’ when a short squeeze will
occur. Even though like I said earlier, negative funding rate does not mean there a lot of
shorts, it tends to become a self-fulfilling prophecy of some sorts as its such a massive
misconception and people believe it to be true, although its not factually true, it ends
up with loads of people piling in longs in the hope of loads of shorts being squeezed.
This will therefore lead to quite a big pump happening, thus fulfilling this prophecy that
negative funding rate = loads of shorts. Hence, when all other factors align from EP2
and EP3 in terms of OI and CVD, if you add a decently negative funding rate, it forms a
very good long setup to take.

However, as always be careful with just using a negative funding rate as an

indication to take a long in the hopes of short squeeze as mentioned prior, it can often
be a topping sign. Use all these tools together to build a complete picture of what is
going on in said coin, and formulate a trade thesis from it.

If you would like to do some further reading on this topic, please check out romano’s
article linked here: https://romanornr.medium.com/bitmex-perpetual-swap-2d125a304dd

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