I’m by no means a professional trader, nor someone who regularly applies technical analysis to the market. I don’t try to time the market on a day-to-day, week-to-week, or a month-to-month basis. I’m more of a year-to-year, and long-term investor. That being said, I’ve been monitoring one particular metric for the last 6 months because from what I can tell, it is forming a semi-reliable indicator for short-term traders. That metric is the futures markets funding rate or open interest.
Once again, I recommend checking out 3 individuals for their weekly/monthly technical analysis on Bitcoin. They cover more than just futures funding rates, so if Technical Analysis (TA) is your thing, definitely check them out.
Definitions for Understanding this Article
Spot Trading - Assets being traded are delivered from the seller to the buyer immediately (“on the spot”)
Futures Trading - Assets being traded are delivered from the seller to the buyer in the future
Long - A market position wherein you think the price will be higher in the future
Short - A market position wherein you think the price will be lower in the future
Contracts (in the trading context) - An obligation to pay (or be paid) in the future
Signals - Indicator or metrics provided by technical or on-chain analysis that helps traders make an informed trading decision
Difference Between Spot and Futures Market
There are two main types of markets - spot markets and futures markets. Spot markets are where traders are buying and selling the asset itself. In the case of BTC/USD, traders are buying and selling bitcoin for US dollars.
Futures markets are where traders are buying and selling contracts (or promises) to buy or sell the asset at a later date. No actual assets are exchanged, or settled at the time of trading.
Reading Binance Academy’s page on futures is great for understanding each of the factors at play within any futures market. It is not crucial for you to understand each factor in order to understand the point that I will be making here. I’m going to lay this out as simply as I can.
What is the Funding Rate?
The funding rate is the amount of interest required to keep either short contracts or long contracts open. Typically the funding rate is settled and adjusted on 8-hour increments (thrice daily). So three times per day, money is taken from holders of one side of the market (ex. Longs) and given to the other (ex. Shorts).
Don’t worry about the details. The three main points and their implications that I think you need to understand are the following.
The funding rate can either be positive or negative in any 8 hour period
If the funding rate is positive
Long Contract Holders pay Short Contract Holders
High Positive Funding Rate indicates that a dip in the spot market is expected
If the funding rate is negative
Short Contract Holders pay Long Contract Holders
High Negative Funding Rate indicates that a rise in the spot market is expected
Keep in mind that I use the word expected rather than inevitable. We can use the funding rate to anticipate what may happen, but it is not a predictor of what will happen.
The interest is taken from the balance of the trader’s margin accounts and given directly to the trader’s margin accounts on the “other side” of the trade.
i.e. Longs pay shorts or shorts pay longs
As you can see from my futures transaction history on Binance, I have a series of FUNDING_FEE transactions that take place 3 times per day. The amount in this photo is negative, meaning these amounts are being subtracted from my margin balance. That is because for the last week or so, funding rates have been positive. Because funding rates are positive, and I have a long open, I need to pay interest on my position if I want to keep the position open.
The interest works out to be pretty small, something like 0.01% - 0.03% on any given day.
How is this helpful to me?
In almost every one of the recent (~8 months) pullbacks (price decreases) or upticks (price increases), the funding rate has been a reliable indicator for what was about to happen. It’s almost as if the funding rate is a proxy to detect when the market is too bearish or too bullish.
A Look at 2 Recent Market Events
Let’s take a look at two of the recent market events to see how exactly funding rates are related to the price movements in the spot market.
Bitcoin Bottomed Out at $28k USD
Again, pointing to William’s letter on July 23rd. He explains funding rates in his letter better than I have, so go check it out.
July 23rd is about a week after bitcoin hit its recent/local low at around $28k USD. He details how bitcoin was moving off of exchanges squeezing tradeable/available supply on the market. He goes on to mention that funding rates are negative (indicating that an uptick in the market may be near). Not surprisingly, we’ve been in an upward price channel since July 17th with funding rates alternating between positive and negative values.
Alternating Funding Rates
When funding rates go between positive and negative, the market, in general, is experiencing healthy growth or decline. Neither the bears nor the bulls are getting too optimistic/pessimistic about the future. It’s only when these funding rates swing too far in one direction that we get a strong buy/sell signal.
Pull Back After Setting All Time High at $66k.
In William Clemente’s most recent newsletter he detected a pique in funding rates on most exchanges and subsequently tweeted about bulls having caution moving forward. This screenshot of his says it all.
If you’re not already following William Clemente III on twitter, do so now. His updates are 🔥.
“Flushing” the Market
When Bitcoin moves violently in one direction or the other, you can expect to hear about liquidations. This means that long or short traders’ positions were forced to be closed and settled. Remember, all future markets are debt-based, meaning that traders need to provide collateral to borrow money to trade with.
In the event that their Loan to Value ratio gets out of balance, they are margin-called or liquidated. This brings an end to their short/long position resulting in a stabilization of funding rates. You can think of these liquidations as “flushing out” irrational market exuberance in either direction. These liquidations are healthy for the market as they sort of keep growth or decline in check.
Think of it like this, if there are too many traders “longing” the market, funding rates rise. This rise in funding rate creates a disincentive for more traders to go long, and an incentive for traders to close their long positions and open short positions.
Furthermore, it creates an additional incentive for short traders to manipulate the spot market in a downwards direction in order to liquidate the long traders and take their money through a liquidation event.
Check out my letter on How I was liquidated and lost $10k trading futures. I was long on the market when funding rates were high. This was a perfect opportunity for short traders to take advantage of people like me.
Futures Reduce Volatility
Because of the function of funding rates and the subsequent reliability in either a buying signal or selling signal, futures markets reduce price volatility in spot markets over time. Ultimately we want bitcoin to increase in price, but we want its growth to be healthy and steady, rather than extremely volatile.
If we see aggressive upward growth, we can expect to see the same sort of volatility in the opposite direction. If we ever wish to see bitcoin reach its potential of being a world currency, it is going to have to achieve a higher level of stability. Futures markets help with this.
How can YOU take advantage of these Signals?
If you’re a daily trader, or a weekly trader, or even a monthly trader then these signals are likely something you want to become familiar with. They’re immensely helpful in providing context into the macro setup of the market at any given point and time.
My intention here is to simply give you another tool to use for when/if you’re trading. Analyzing funding rates (with the help of Willy, William, and Dylan) can help you time a good low in the market (entry point) or a good high in the market (exit point). Of course, none of this matters if you’re simply buying and HODLing for the next 5-10 years.
Will I Trade the Volatility with this Signal?
Since I trade with about 20% of my portfolio, I may start to play around with a small amount of money using this signal (as well as others provided by Will C, Willy Woo, Dylan) as my guiding principle. I’ve watched the last 6 signals come and go without putting money on the line. I am currently playing around with futures markets on Binance, but I am simply keeping a low-risk long position open through the dips.
If I wanted to “up my game” I would follow these signals and take profits when funding rates increase too much. I’ll be sure to update you on how I make out this time, since the last time didn’t work out too well for me. I can’t help but play with 🔥!
Regards,
Keegan