Futures trading has grown tremendously over the last year, as evidenced by the overall increase in open interest. The total number of open contracts is open, and that number has risen from $ 3.9 billion to $ 21.5 billion in six months, an increase of 450%.
Traders sometimes assume that high or low funding rates and growing open interest indicate an upward market, but like Cointelegraph explained this is not the case before. This article will quickly look at the level of funding and how traders interpret metrics when trading perpetual futures contracts.
The funding rate can be a bull or a bear
Permanent contracts have an embedded rate that is usually charged every eight hours to ensure that there is no imbalance in exchange rate risk. Although the open interest of buyers and sellers always coincides, their leverage effect may vary.
When longs require more leverage, it will be they who pay the fee. Therefore, this situation is interpreted as bullish. The opposite is true when shorts use more leverage, which causes a negative level of funding.
Whenever traders use a high level of leverage, analysts point to the risks of cascading liquidations. While this is true, this situation can unfold for weeks and sometimes deleverage will occur on its own. Therefore, such an indicator should not be used to predict local peaks, as the data show.
Bull markets usually cause a positive level of funding when buyers get overly excited. Nevertheless, this situation creates a perfect storm for short-selling sellers, as the 5% price correction severely eliminates longs with 20x leverage. These orders could push the price down, causing a 10% drop and then triggering a cascade of liquidations.
For this reason, scientists and analysts often identify excessive funding rates as the main cause of cascading liquidations when the market turns red, although funding rates may remain unusually high during bullish runs.
The funding rate can detect local bottoms
Notice how the funding rate was 0.15% and higher on the eight-hour session during February, when no local peak was created. This rate corresponds to 3.2% per week and is somewhat burdensome for traders holding long positions. Thus, attempting to time market peaks with this metric rarely yields good results.
By contrast, BTC price days on 27 January and 28 February took place during periods when funding levels were low. These moments showed that traders were not willing to use longs, and this proves that they lack trust on their part.
The low level of funding must be seen in context
While this indicator can help determine if a local bottom has formed, it should definitely not be used on its own, as the funding rate will usually dissipate after any strong price correction.
In addition, a persistent period of high funding will attract arbitrage traders to sell perpetual futures while buying monthly contracts. Therefore, this metric should be used with caution.
To confirm investors’ distrust in opening markets, we should monitor a monthly contract premium, known as the “base”. Unlike a permanent contract, these fixed calendar futures do not have a funding rate. Therefore, their price will be significantly different from regular spot exchanges.
By measuring the difference in costs between futures and the regular spot market, a trader can measure the level of bullish development in the market. Whenever there is excessive buyer optimism, a three-month futures contract will trade at an annual and premium premium of 20% or higher (base).
The combination of indicators may reveal local BTC price bottoms
On the other hand, when an indicator indicates a local bottom, it usually means that traders’ confidence is gaining strength. Thus, in a scenario where the level of funding for standing contracts is low, there is better “confirmation” from buyers who use low leverage.
By combining the financing rate of permanent contracts with the monthly contract base, the trader will get a better overview of market sentiment. Like popular “fear and greed” indicator, traders should shop when others show distrust.
This scenario usually occurs when the funding rate is less than 0.05% in eight hours and the bottom of three-month futures, as shown in the chart above.
The views and opinions expressed herein are those of an opinion author and does not necessarily reflect the views of the Cointelegraph. Every investment and business move involves risk. You should do your own research when making your decision.