Funding rate – A must-know for the boldest investors
If you’re planning to trade futures contracts, you need to know how the funding rate works. It’s one of the biggest factors that will determine how much you’ll earn from your investment. If you’re not careful, the funding rate may put a stop to your contract!
Some readers may not even know what a futures contract or a funding rate is. In that case, let this be your introduction to one of the riskest investment methods for stocks and crypto. This article will help you learn a few of the basics so that you can minimize risk on your first try.
Before I explain how a funding rate works, it’s important to discuss how futures contracts work. After that, I will discuss how this factor works in crypto contracts. More importantly, I will show you the benefits and risks of futures contracts, so you can decide whether or not to use them.
How do regular futures contracts work?
The funding rate is an important part of a futures contract. It will be difficult to understand if you’re not familiar with how a future contract works, so let’s talk about it first.
A futures contract is a trading method that involves purchasing or selling a stock at a future date while buying it at the current market price. That’s how futures contracts got their name.
Investors use them when they think the stock price will likely go up or down later. The “contract” part refers to their expiry date.
You agree to lock your funds for a purchase or sale of stock once that expiry date comes. This means holding either a long or short position for that asset.
A long position assumes that a stock price will increase, so the investor earns as it rises. Meanwhile, the short position sees the price going down, so the investor profits as it goes down.
The tricky part about a futures contract is that it depletes the money you’ve put in if the price moves against your position. If the price goes up or down too much, you may get liquidated.
That’s when the market closes your long or short position, and you lose all the money in them. You could maintain your contract by paying long or short positions even more money.
This is when a futures contract becomes highly risky for an investor. You may look to the recent news about Gamestop as an example. It started from a few people on Reddit.
Those folks had enough rich investors earning from dying companies via short selling. They thought the rich were taking advantage of their struggle during the coronavirus pandemic.
With the help of investment apps, they decided to keep buying shares of these failing businesses. This meant the stock prices went against the short positions.
Wealthy investors thought this was no reason to worry, so they just poured more money into their positions. As a result, they lost millions of dollars.
What is the funding rate?
The cool thing about the crypto market is that it allows investment options that are not viable in other assets. Again, let’s take a look at traditional futures contracts as an example.
Those have a set date when your position must end. In the crypto market, you have what’s called perpetual futures contracts. As the name suggests, you can keep them going forever!
That “forever” ends only if your position gets liquidated. If that’s the case, how would these contracts settle? After all, the contract price and the spot price can’t “meet” if you don’t have a specific date!
That’s why this type of derivative exchange needs the funding rate. This is the periodic payment that goes either to long or short positions. The interesting part is that they’re peer-to-peer.
The open positions pay for each other depending on whether the funding rate is positive or negative. Learn more about this payment system below:
- A positive funding rate means the perpetual contract price is higher than the market price. This means traders with long positions pay for the short positions.
- Meanwhile, a negative funding rate means that the contract price is lower than the marked price. That’s when short positions pay funding rates for the long ones.
Read More: Check Out The Biggest Investment Trends!
How does the funding rate work?
Here's the Top UM #Binance Futures trader of the day!
Click below to follow them and other top traders👇
— Binance (@binance) September 23, 2021
The funding rate changes depending on the spread. To understand this, let’s revisit how people buy and sell cryptocurrencies. You set the target crypto price and how much you want to pay.
Once you confirm the buy or sell order, another must accept your target price. The gap between the target and market prices is called the spread.
The spread is too wide, so the traders experience slippage. This is when people struggle to buy or sell due to a lack of buyers or sellers. As a result, people can’t execute trades.
For crypto futures, investors must allocate more money to retain their position. As the spread widens, the amount you need increases. This is a crucial part of the funding rate called the premium.
The other part is called the interest rate, and it varies depending on your trading platform. Binance is the most popular crypto exchange, so I’ll use it as an example throughout this article.
It maintains a fixed interest rate of 0.03% every day and 0.01% for every funding interval. The only exceptions are contracts for BNB/USDT and BNB/BUSD, which have a 0% interest rate.
The funding rate is made up of the interest rate and the premium. You will need to pay attention to these factors to earn from crypto futures contracts.
Should you try futures contracts?
.@binance futures started limiting new users to max 20x leverage last Monday, Jul 19th, 7 days ago. (We didn't want to make this a thingy).
In the interest of Consumer Protection, we will apply this to existing users progressively over the next few weeks.
Stay #SAFU. 🙏
— CZ 🔶 Binance (@cz_binance) July 26, 2021
The biggest reason why people like futures contracts is because you don’t have to hold the asset in your portfolio. Take USD-M Futures as an example.
You just need the USDt (Tether) stablecoin to profit from the price movements of various cryptos. The newly-released coins are usually off-limits, though.
Another reason is the potential for high rewards. Crypto futures let you assign leverage on your position. They let you borrow funds to earn from your longs or shorts potentially.
Experienced traders use them to hedge their portfolios. Let’s say you’re hoping a crypto price goes up, but you prepared a short position just in case.
Sadly, the price crashes, so that crypto-token in your portfolio falls in value. Fortunately, the short position allowed you to earn from that decline, so you may end up still earning money.
Follow enough cryptocurrency news, and you’ll know how people dislike its price volatility so much—investing in futures contracts cranks that uncertainty up a notch!
The funding rate will change depending on how the spread widens or contracts. That depends on trader behaviors which are also unpredictable!
Worse, leverage can send you to bankruptcy within seconds. The recommended leverage level is 25x, but some people go as far as 100x and 150x.
Then, they leave the position open for the night. In the morning, they find they’re thousands of dollars in the red! That’s why you must be highly careful when using such trading strategies.
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Final thoughts
This doesn’t mean you shouldn’t use futures contracts. You’re already in the right direction by learning more about how the funding rate works. Besides, there are ways you can minimize risk.
For example, you place a stop loss on your position to prevent losing too much money. You can be extra careful by placing a Take Profit, so you’re sure to earn from your position.
This article is not meant for investment advice. Learn all you can about assets and plan properly before investing. Only use the money you’re willing to lose.
