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Understanding Bitcoin Funding Rate

By Laxmikant Khanvilkar

Funding rates are periodic amounts of an asset paid between short and long traders that hold perpetual contracts positions. The reason for funding rates is that perpetual futures contracts, as their name suggests, can be held indefinitely without expiry.

Positive funding rates indicate that long-term traders have the upper hand and are willing to pay funding to the short-term traders. Many traders are optimistic because funding rates are positive. Negative funding rates suggest that short-term traders have the upper hand and are willing to compensate long-term traders.

Funding rates make the perpetual futures contract price close to the index price. It is made closer to the spot prices and covers some of the gap generated by the perpetual period of time. All cryptocurrency derivatives exchanges use funding rates for perpetual contracts and the standard unit is a percentage.

What does it mean when funding is negative?

As an indicator, the funding rate can be used to determine the sentiment of the market. For example, negative funding rates are a sign of a negative sentiment. This is because traders have such strong beliefs that the market is going down that they are paying a premium in order to short it.

Funding rate can serve as a sentiment indicator of sorts. When it is high, there is a high interest in long trades on leverage, whereas a low or even negative funding rate shows that the short is quite crowded.

One tip to make some “passive income” from funding rates is to buy AND short the exact same amount of the cryptocurrency you put your money on. This method balances the positive and negative funding rates, where technically you do not have a position in that particular cryptocurrency market since it is counterbalanced.

If inflation goes up, the price of bitcoin will tend to go down. Conversely, if inflation “slows”, for example a favorable reading of the American consumer price index, then asset prices will rise including bitcoin — with a view on the Federal Reserve and other central banks slowing interest rate targeting increases.

Funding is calculated like an interest rate, and is determined by a funding rate that is adjusted algorithmically based on the price of the underlying & market prices for the Perpetual. The main driver of the rate is how far the Perpetual’s market price is from the index price.

The funding rate is a mechanism used in these contracts to ensure that the market price of the derivative remains close to the spot (actual) price of Bitcoin. It’s designed to prevent large discrepancies between the derivative’s price and the actual market price of Bitcoin.

Here’s How it works?:

1-Longs vs. Shorts: In cryptocurrency derivatives trading, traders can take two main positions: long (betting on the price going up) and short (betting on the price going down).

2-Funding Payments: The funding rate is the mechanism that transfers money between long and short traders. If the funding rate is positive, longs pay shorts. If it’s negative, shorts pay longs.

3-Market Imbalance: The funding rate is calculated based on the difference between the derivative’s price and the underlying index price (which is usually the spot price of Bitcoin). If the derivative’s price is significantly higher than the index price, the funding rate becomes positive, encouraging longs to pay shorts.

4-Balancing the Market: This mechanism helps to balance the market. When too many traders are on one side (e.g., too many are going long), the funding rate becomes positive, acting as a deterrent for excessive long positions.

5-Preventing Manipulation: The funding rate mechanism helps prevent market manipulation. If a large number of traders artificially inflate the price of derivatives, they would have to pay significant funding costs, making such manipulation less attractive.

6-Incentives for Traders: Traders who correctly predict market direction might earn profits not only from price movements but also from funding payments.

It’s important to note that the funding rate varies over time and can change frequently, often every few hours. Traders need to monitor it closely if they’re involved in trading on derivatives exchanges.

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