The Funding Rate | Supplementary Material

Hi guys, what's going on? This is Ryan with blockroots and in this trading strategies video we're going to be talking about the funding rate and how you could potentially use it to establish an edge in regards to directional bias for one of the assets on the derivatives exchanges. So when we're talking about the funding rate, we're talking about exchanges like Bybit, Bitmex and Deribit. Bybit being my personal favorite. If I was going to use one of them in terms that it has rather in regards that it has the fastest matching engine and I'm going to go with the tech every time Bitmex takes it home in regards to the overall volume of the market currently. Now, traditional futures contracts have an expiration and a settlement. Perpetual contracts don't. They are essentially synthetic margin trading derivatives of an underlying asset. Now these contracts are based on spot prices. We'll use Bitcoin for example. They're based on the spot price of bitcoin on multiple exchanges. Now traditional futures contracts can trade at a different price than the underlying spot price of the asset they're based on. This is where you'll hear the term basis or contango or backwardation in the case of contango if we are above the spot price or backwardation if we're trading below. Now the perpetual inverse swap contracts, they need to equal the underlying spot price. They need to equal the underlying spot price or in the case of the averages of the underlying spot prices based on the oracles that they're using or the exchanges that they're basing the contract on. So how does the exchange with the derivative that's offering a tremendous amount of leverage in a case which can move price extremely in either direction, how does it stay tethered to something like an index that is made up of underlying spot price exchanges? It stays tethered to this through the use of a funding rate. So the funding rate is a mechanism used to incentivize traders to take the opposite of the trade that is currently popular. So this incentivizes traders to close out positions in order to move the price back to the underlying spot price. So the funding rate when it's negative means that shorts pay longs. When the funding rate is positive, this means that longs pay shorts. So the funding rate is essentially like the interest that you are paying if you keep the position open past the eight hour expiration period. So if you keep the position open, you pay the funding rate based on the notional contract value. So even if you have only $10,000 on the exchange. If you lever up 10,000 or rather 10 times and trade on behalf of 100,000 contracts, you're paying the funding rate based on the $100,000 value, not the $10,000 underlying. So this can be very costly, especially if the funding rate is at extremes. So in the case of the funding rate, rather though you can close out before the funding rate expires. So even if you're long and it's costly for you to be long, if you close out right before the funding rate expires, you don't have to pay and then you can just reopen your trade. So you could see, I think quickly, how this could potentially have an effect on overall price action. Let's just use price action as an example. Let's think of the price action leading up right to this. So what do you think is going to happen if, in the case of the funding rate being tremendously positive? Okay, what do you think is going to happen with longs? Most longs will likely close out because they don't want to pay the funding rate. They'll likely close out because they'll be paying shorts. That funding rate shorts don't have to do anything. In this case, they're getting paid to do nothing, to just be short. So it's actually, they're actually making money just to be short. In the case of the funding rate being positive, in the case of the funding rate being negative, longs are making money to be long, even though the popular trade is short. When the funding rate is at extremes, this is detrimental to the traders who have large notional contract values in terms of. It costs them a lot of money to keep this position open. Now, when the funding rate begins to shift, we could consider this as a potential turning point. We see it as traders potentially setting up and shifting positions. The funding rate starts moving positive. It tells us that maybe the popular trade is becoming the leveraged long trade. Right. So we can see the funding rate on each of these exchanges. We could use something like Tensor charts. I like Tensor charts. I don't like the heat maps on Tensor charts, but I do like the Bitmex data that it gives you. There's another great site called skew, sk3w. It's a great site as well. It gives you great derivatives, futures exchange information, options information in regards to Bitcoin. Alright, all of this can be tremendously valuable if you're trying to establish some type of edge. Now, when the funding rate begins to shift, let's say for example, around an area that we are coming to at a major area of support, maybe we'll say that this is potential turning point because longs are getting ready or maybe when it's beginning to shift, rather when it's beginning to shift negative, maybe at that point it's because we're approaching a major area of resistance. The funding rate is maybe shifting negative and it's indicating that shorts are getting ready. So this gives us maybe an insight into what the underlying actions are of the participants in the market. Now, another thing that this potentially sets up, which I think is a bit more useful, is squeezes. So when the funding rate is extremely negative or extremely positive. So think of when a majority of the market or when the market is levered long, when a particular area is crowded in terms of longs or shorts, what does this end up causing? If the market is pushed in the other direction slightly, this will cause a squeeze. So what we have is when we have the funding rate that is either extremely negative or extremely positive with a really high open interest, this could give us some insight into where a really crowded trade exists in one direction. Now, how we actually go about using this requires some sharpening. Obviously, this is not just say, oh, you learned that the funding rate is high and then therefore the market is going to move the opposite direction. No, what this does is it gives us some type of insight into maybe where potential bottoms or tops might be, where we could expect that maybe there might be a potential short squeeze setting up. If you're a larger trader and you're a larger aggressive trader, you might even try to tip the scales yourself. The funding rate can help us identify where the crowded trades might be. The funding rate can also help identify where potential areas of volatility might occur. So in the case of the funding rate coming close to expiration, we could expect that maybe there'll be an increase in volatility as potential.

Rather, as traders who might potentially have to pay this funding rate close out their positions all at once. So you might see a spike in volatility. Now, mind you, that you can close out your position before you have to pay and then reopen it after. So we actually might see a smoothing of price action over an average. We might see that this has less of an effect than it actually does. Add indicating where potential squeezes might be. So I mentioned open interest. This is not volume. This is rather the total outstanding contracts. So if you are trying to understand what this means, think about how I mentioned that areas might be crowded. So when we see something like open interest, for example, and we See that open interest is really high. This can help us identify where areas might be where there are trap traders, for example, especially when there's a extremely high or extremely negative funding rate. So the funding rate is just something that you can add to your skill set to try to identify, like I said, where these potential areas might be, where price might turn back, or in the case of everyone closing out at the same time, where there might be an increase in volatility. But now where do we access this information? I'll give you an idea real quick. I'm going to go on to the actual Tensor program. It's a Tensor platform. You could get this information for free by using their free version, or you could pay and you get a little bit more access to some of their tools. I do not sponsor Tensor whatsoever. They are not paying us to say this. It just happens to be the exchange you can go to to get this information. If you don't want to go into bybit, if you cannot log into BYBIT because of the, the restrictions, even though you can see the live trading without going out to the exchange, but going on to Tensor allows you to access this information without going out to the exchange, same as going out to sku, you can access this information as well. So let's take a look at a chart real quick and we'll give you an idea what the open interest looks like and what the funding rate looks like. So here is the actual Bitmex chart. This is the Bitmex chart on the one day. And what we have under it is the open interest. So the total outstanding contracts that are currently open and not closed out. So this is the actual chart of that value changing over time relative to the actual bitmax chart. So this day up here is the open interest over here and so forth. It's in tandem with that below here we have the actual buy and sell liquidations, which we're not going into. But then under here we actually have the funding rate. So you can see that over here the funding rate is really, really high. So this is a really positive value. In this case. This was an area where the longs were going to be paying the shorts to keep their positions open.

Or rather, when they did keep their position open past the funding rate expiration, they would have to pay the shorts the funding rate in this area. Shorts actually made money from longs. Just to give you an idea how that works. Again now, when we were talking about open interest, we have a separate lesson on open interest. And what that is is basically the outstanding contracts Shorts long, so forth. Now, what we want to see in a healthy market that's moving up is we want to see open interest going up when the market is going up and when the market is pulling back, we want to see open interest decreasing. What we don't want to see is that open interest is increasing as the market is moving down. This might give us some potential insight into maybe more shorts piling up, in this case adding downward momentum rather than actual selling. Because this is not buying and selling volume. This is just total positions open. Now, when we're talking about using these together, we'll give you an idea about that term I was talking about when I was saying crowded area or crowded trade, you could see that around this area where we had the blow off top, this was an area where I said there was a massive spike in open interest, typically at tops. What you'll see is that is where everyone jumps in. Everyone jumps in. Because at that point anyone who's on the sidelines is like, I don't want to miss this. This thing is going to the moon. That is when the last of the investors and traders who were out of the market, they jump in at once. And that is the area where price turns pack. So that's the FOMO area. So the massive spike in open interest, the massive spike in the funding rate, this showed us that the market, the popular position, was leveraged long. And in this case, all the market has to do is cascade down, forcing all of these positions to need to close out their leveraged longs. Now, it doesn't have to cascade and then cause that. What I mean was rather the progression of that is that the market has to move against them to force them to be trapped. In this case, being trapped above this position, having opened late longs, being trapped and then needing to close out, giving the momentum, or rather the downside momentum, fuel. So this is an example of what I was talking about was when I was talking about spotting these particular areas where there are these really extreme values. So in this case, where the funding rate is extremely positive, and you can see that coincides with our top, okay, this peak right here, we see the increase. If I had a straight line, this chart would be great. We see the increase in the actual funding rate, indicating to us that in order to get this value back down to the underlying spot, price longs would have to potentially close out and take the other side of the trade in order to move this price down. Now, that's the mechanism in order to do that. But what this does is gives US some insight into where the market is crowded, what is a crowded trade rather? So the same works with a really negative funding rate. So in the case of a really negative funding rate, we would say the same thing. Maybe what the setup that is occurring is a short squeeze. And I think you could see that we had a little bit of what looks like a squeeze up here when we had a really negative funding rate and the market moved up. Give you an idea of how you might interpret the potential. Rather the situation preceding that is that the move up entirely for this move was on high open interest. The pullback was on a decrease in open interest. We want to see that. But open interest is really high. Majority of the market is likely confident in this trend. In this case though, everyone was trying to short this move, thinking that we deserved a pullback, that we needed a pullback. The entire move up the thought was that we needed a pullback.

Remember, the market can remain irrational longer than you can remain solvent. So what happens is the popular position indicated by the negative funding rate was what we likely had a lot of shorts that were trapped in this position as price began to move up. So what happens? The market squeezes. So this gives you some idea as to how you can identify where these potential, rather the funding rate will give you some insight into whether or not an area might be setting up for a potential squeeze, whether or not we might be setting up for the case of a top or a bottom. So this is just one of those things that you should add to your tool set, rather your skill set or both, so that you can potentially develop what is considered an edge in the market. So what gives you rather the probabilistic advantage in determining something like the near term direction or the long term direction for Bitcoin? So in the case that we're talking about Bitcoin right now, you could use these derivatives exchanges. Some of the other derivatives products are based on Ethereum, on Litecoin and on Ripple. And I'm sure that in the future with these peer to peer funding exchanges, rather these peer to peer derivatives exchanges where you're trading against someone else, this is zero sum game. This is absolute zero sum game where you have to pay the other side in order to keep your position open. If that's a crowded trade, this will be useful.

In those assets as well. So that's it, guys.

Take a look at this, see what you think. See if you're able to spin it in your own way.

Just to give you an idea of this dotted green line, what the dotted green line is, especially if you go down to the lower time frames. You can see this a little bit more clearly. The dotted green line is the predicted funding rate. So this is the rolling calculation of where the funding rate is likely to be. So every eight hours the funding rate expires, and that's why there's these little segments. But the predicted funding rate gives you an idea of where the funding rate is potentially headed to. Okay. Before it actually resets. So that's that, guys. Alright. Hopefully that was very informative. If you have any questions. As always, this is Ryan with block roots exercise, proper risk management and trade effectively.