Understanding Funding and Its Purpose
Let's start by providing some context for the use of funding mechanisms, so you can better grasp the essence of this term.
A futures contract is an agreement between two parties to buy or sell an asset (in our case, cryptocurrency) at a predetermined price in the future. This means that acquiring futures allows traders to lock in the price of an asset, even if market prices fluctuate.
Think of it as making a deal with a friend to sell them your sneakers for $70 next Thursday when they receive their paycheck. Both parties know the date and price. If there's a sudden shortage of those sneakers nationwide, causing their price to skyrocket to $150, it doesn't matter. A deal is a deal.
The agreed-upon price is called the spot price. It gets its name from the phrase "on the spot," signifying the amount you would pay for the purchase right now. When you buy Bitcoin or any other cryptocurrency on an exchange, you pay the spot price, not the price for next Thursday.
The difference between the price at the time of the trade and the actual price on Thursday is the trader's profit or loss.
Typically, futures contracts have a specified expiration date, but in the crypto world, they are often perpetual. To balance spot and futures prices, a funding rate is used. It smooths out the price fluctuations of perpetual contracts and keeps them as close to the spot price as possible. For a trader, the funding rate is the cost of holding a position, while for the exchange, it helps maintain price equilibrium.
Funding rates usually amount to a fraction of a percent. However, this morning, I entered a trade with a 3% funding rate, and I suffered an immediate loss as a result.
IMX Financing Rating Table
Next, we will understand how financing is calculated, how to avoid mistakes and losses, and most importantly, how to earn from financing rates.
How Financing Works and How to Calculate It
So, we have already established that financing is a small percentage of the value of your position that you pay (or receive) from traders on the other side of the trade.
Most exchanges use payout intervals of 1, 4, or 8 hours. Most often, payouts are made every 8 hours, as we can see in the screenshot above.
Positive and Negative Financing Rates:
Financing rate is positive when the perpetual contract is traded above the spot price. Long traders pay a commission to short traders.
Financing rate is negative when the perpetual contract is traded below the spot price. In this case, shorts pay longs.
Essentially, the financing rate creates a fee for one side of the trade and compensation for the other. This serves as an incentive to keep the perpetual contract closer to the spot price.
How Financing is Calculated
The financing rate consists of two parts:
- The interest rate is fixed and set by the exchange (but it can vary for each cryptocurrency).
- The premium (or discount) changes depending on how much the perp (contract) price differs from the spot price.
Sometimes exchanges use different terms to denote these rates, but the essence is that one part moves to fill the price gap, while the other remains unchanged.
The basic financing rate is calculated as follows: position size multiplied by the financing rate.
For example, I opened a short position on $IMX at $700, and the financing rate was negative at 3%. Just so you know, this is a LOT, but I didn't check it before opening the position.
Another detail was that the financing payout was a few minutes after opening the position. As a result, despite a positive PnL from the movement of the $IMX price, I ended up in the negative due to financing, paying $21.
You don't need to manually calculate your funding amount to avoid my mistake. Use ready-made tools and always check the rate before opening a position.
For example, you can do this on Coinglass.
How to Earn from Financing
And now let's get to the most interesting part: how to profit from financing. As you remember, traders pay each other the financing rate based on the market conditions: either longs pay shorts or shorts pay longs.
It's not possible to make a profit from it because the price movement of the asset will most likely put you at a loss. But there is one trick.
For example, you see a positive rate of 2%. This means that longs will be paying shorts. In this case, we can open two positions of equal size:
Buy the coin on spot for $1000.
Open a short position for $1000 on the same coin.
These numbers are given as an example; you can substitute your own. This way, the potential loss from the futures contract is covered by the profit from the spot trade. At the same time, we receive 2% of the trade size every 8 hours.
It's only $20, but it's risk-free. And you can scale this strategy depending on the size of your deposit.
Another way to profit from financing is to incorporate it into your trading strategy:
- Positive rate = contract price higher than spot price = it makes sense to open a short position.
- Negative rate = contract price lower than spot price = it makes sense to open a long position.