For the Funding Cost in Trading Perpetual Futures, You Can Buy an iPhone
Even if you’re only a regular retail crypto trader, the cost of trading perpetual futures is still surprisingly high
There is something wrong with the crypto industry.
Price volatility, token sales, new technology hypes. We’re all thrilled and amazed by how fast the industry grows. But at the same time, uneased by how swiftly the industry changes.
The new technology unfolds possibilities of advanced trading at an unprecedented speed. While it takes time for engineers to perfect products, rules, and policies, it doesn’t mean that we should be happy and never ask questions.
We’re all screaming for transparency.
Exchanges are being unclear about trading rules and costs. They are not deliberately hiding the information, but the swift development has made it difficult.
At ACDX, we want to change that. We look to improve the standards and make the operations of crypto exchanges more transparent. Today, we’re going to examine the perpetual futures funding rate.
First, what is funding rate?
In futures trading, there is a rather significant difference between the futures market price and the spot market price. The difference is represented by basis.
As a futures contract settles at the end of the term, whether monthly or quarterly, the futures price will converge with the spot price over time.
But unlike a traditional futures contract, perpetual futures never expire. Exchanges need a mechanism to keep the traded price of the perpetual futures market in line with the spot market.
Therefore, funding is introduced. Perpetual futures settle every few hours (depending on the exchange) to ensure the perpetual futures market price is tethered to the spot market price.
When the market is bullish, the funding rate is generally positive and longs pay shorts. When the market is bearish, the funding rate is generally negative and shorts pay longs.
The funding rate is correlated to the price change, instead of the price itself.
The devil is in the details
From the above mechanism, we can tell that whenever you are following the market sentiment, you very likely have to pay the funding.
The funding rate does appear to be an insignificant number. But after we gathered the historical data of the funding rates of different exchanges and did some calculations. We have some surprising founding.
The above shows the average daily funding rates of the exchanges for BTC perpetual futures in August 2020. This means if you go along with the market and hold a $1,000 position, you will have to pay around $2.5.
Right, the cost is still very low. But then we dug deeper, comparing the numbers on an annualized rates.
Now, let’s assume you hold the $1,000 position for a year and somehow never get liquidated. You will have to pay more than $900, which costs you an iPhone 11 Pro.
Though you may argue, one does not hold a position for a whole year. There are still costs in opening and closing positions at uncertain prices, and funding should never be ignored if you’re trading regularly.
Then what about quarterly futures?
Futures trading does not have a funding mechanism. However, the contract expires on an agreed date.
As futures spread is not yet introduced to the cryptocurrency market, you will not be able to maintain the same risk position. Instead, your position will be settled on expiration and you’re forced to open a new position for a new contract.
This inevitably increases your cost of trading. Also, you’ll never know if the market would move significantly between your positions closing and opening executions.
So which is better? perpetual futures or quarterly futures?
There is never a definite answer.
If you’re a retail trader and you don’t have the luxury to stare at the charts all day, perpetual futures could be a more convenient option for you.
But if you’re an institutional player, well, I believe you already had an answer.
Trading behind the mist
Futures contracts offer a much clearer trading cost. Unlike the ever-changing funding rate of perpetual futures, you can better calculate the costs and control your risks.
This is especially important for traders managing a considerable amount of funds.
Although exchanges do not charge any fees on funding and it is exchanged directly between traders, funding is still — I would say — a real pain in the ass.
Don’t get me wrong. There are still a lot of advantages perpetual futures can offer with the frequent settlements, say, better capital efficiency.
However, funding adds more unforeseeable elements to the world of derivatives trading, which is already complex enough. And sophisticated traders would make every effort to avoid any incalculable factors.
From opaque to transparent
So, can we make funding rates more transparent?
Unfortunately, funding rates are directly correlated to the spot market price, meaning that it is impossible to predict accurately. Exchanges are already doing their best to provide the rate of the next settlement.
As said, both futures contract and perpetual futures have their own pros and cons. A lot of factors have to be weighed in before coming to a conclusion of which product is best suited for you.
However, at ACDX — as we are traders ourselves as well — we figured it is the fundamentals that are needed to be solved. Instead of choosing between the two, we see endless possibilities in improving and introducing more products.
In the next article, we’re going to introduce some new features at ACDX and explain how we can help you to be more efficient at your trades.
Disclaimer: The contents contained herein are for informational purposes only. This is not an investment advice nor should be treated as a substitute for services of a certified financial advisor. Any reliance placed upon the information provided in this document, and the appropriateness of opinions, assumptions and qualifications used, is a matter for the reader’s own commercial judgement.
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