The Signal in Bitcoin’s Funding Rate
The downward trend has extended for weeks.
Your favorite analyst is telling you prices are likely to reverse due to negative funding rates. And all you can see is doom and gloom on your Twitter timeline.
You are not sure what to think of it… But what you do know is negative funding rates for bitcoin means traders are piling into short positions. And as you look at the chart you wonder how the trend can reverse as nothing is suggesting a trend reversal is coming.
As you open up your trade you immediately ask yourself how long to keep the trade open. Is this a short-lived rally or a true market reversal…
The answer here is not, “it depends”. Instead, there is actually a signal in bitcoin’s negative funding rates just mentioned. The key is knowing how to profit on this signal. It is what separates successful traders from the rest of the pack.
And today we look to break this signal down and show you the hidden alpha embedded in funding.
What are Funding Rates
First, let’s unpack some fundamentals.
For the uninitiated, the funding rate represents the cost or profit to carry (maintain) a trade in the derivatives (futures and perpetuals) market. The rate can be either neutral, negative or positive.
Let’s use Bitcoin (BTC) as an example.
When there are more positions long perpetual futures contracts, due to the demand, the buyers will have to pay the sellers for opening up sell positions. This is a situation where funding is described as being positive.
If there are more positions short (selling) the perpetual futures contract, the reverse happens and the sellers pay the buyers for opening up these positions. This scenario is an example of negative funding.
The funding rate is a good sentiment gauge for how traders are positioned in the market.
Thus, if the funding rate is positive, sentiment is more bullish and vice versa. And the more extreme the sentiment, the more extreme the funding rate can get.
In euphoric periods this funding rate can climb well above 0.2 to 0.3% every eight hours. Meaning the cost to keep a position open is more than 300% if it were held open for a year.
However, due to the mechanism of mean reversion, the funding rate will always adjust and balance its way back to neutral. This is where the common strategy of longing when funding is negative and shorting when the rate is positive comes in.
So getting back to our original question, is there a profitable strategy here…
The First Test
To start off, let’s assume a trader opens up a long position when funding rate flips negative. Then holds the position open for 48-hours.
The chart below shows the maximum downside for this individual within the 48-hour periods. As you can see, there are a lot of bars in the negative… Which means this is not just a losing strategy, but risky as well.
But what if we tweak the time period and close the bitcoin position BTC before the 48-hour period…
To determine if anything is worth exploring further, we took a similar approach as before, but used an 8-hour, 16-hour and 1-day time frame.
Again, this means the trader is buying BTC the moment funding turns negative funding and selling when the metric turns positive.
As shown below, back-tested data recorded the past performance of each BTC purchase within the three proposed intervals of negative funding. The Y-axis reflects the percentage of return and the X-axis is the number of occurrences.
What we see is that the 8-hour, 16-hour and 24-hour time frame for scalping spent much more time in the positive. In fact, 5%+ returns were frequently being realized. This tells us we might have something here…
One important tidbit is we used funding rates from Binance, which resets every 8-hours. FTX resets each hour. Be sure you understand how often your exchange resets funding before trying out a similar strategy.
Taking it One Step Further
For those that want to see what these strategies look like over time, we included the backtesting chart below. One thing to note is the strategy can be used in bull and bear markets. Meaning there is no secondary overarching model that needs to let us know the market environment we are in.
Diving a bit further into the backtest, there are four lines. The green line is simply buying and hold. You can think of this as bitcoin’s price over time. The yellow line is the 8-hour strategy. The orange is 16-hours. And red is 24-hours.
All three strategies generated positive returns since the summer of 2021, regardless of the overarching trend.
The orange line, which is the 16-hour strategy performed the best of the three strategies.
What we see is that funding rates are in fact a reliable indicator in the market. But it comes down to how the indicator is used by the trader.
While these funding rates are not reliable when it’s past a 24-hour time period, they are in fact reliable on a shorter time frame. So while BTC funding rates might not indicate a larger market trend reversal as your favorite analyst might have you believe, they should not be ignored.
We (Benjamin and Ben) hoped you enjoyed this piece from the team at Jarvis Labs. Special thanks to Arithra for conducting the backtest and Michael for translating the work into this essay.
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The Jarvis Labs Team