Definitions & FAQ for Funding Rates
What are perpetual contracts?
A perpetual contract is a crypto futures contract without an expiry date. Like a futures contract, a perpetual contract is a derivative that derives its value from the underlying crypto asset.
You can buy/sell the underlying crypto asset at a pre-agreed price but close it whenever you deem fit. The pre-agreed settlement price is the price of the crypto asset at the time of opening the contract.
How perpetual contracts work
A perpetual contract enables traders to speculate on the underlying cryptocurrency’s future price movements. Let’s understand this with an example.
Assume BTC is currently trading at a spot rate of $30k, and you expect it to reach $40k within one month.
So, you buy/open a futures contract of 1 BTC at $30k with an expiry of one month.
But suppose BTC is trading at a spot rate of $38k after 20 days. You believe it’s a good opportunity to register an $8k profit and don’t want to wait till it hits $40k.
You can settle this order in two ways:
- Closing the same open futures contract by selling it at $38k.
- Setting up a fresh sell futures contract at $38k. This will cancel out your already open buy futures contract, which you had purchased for $30k.
In both cases, you’ll profit around $8k.
If you don’t close your futures contract before its expiry, the platform will automatically settle it upon expiry at the market rate.
The perpetual futures contracts work almost the same as above, except for a few modifications.
As a perpetual contract doesn’t expire, you’ll need to close it manually or set up a reverse trade for its automatic closure at a specific price point.
The exchange may also liquidate your position automatically if your leverage maintenance margin falls below the required threshold.
What are Perpetual Funding Rates?
Since perpetual contracts don’t expire, their value can differ from the spot rate. In a bull market, a 1 BTC perpetual contract could trade at $30.1k, even if BTC is trading at $30k in the spot market.
Therefore, to avoid their loss, exchanges implement a price anchoring mechanism called funding rate. This is done to keep their price closer to the spot rate.
If the price of the BTC perp is higher than the BTC spot rate, the buyers of the perps (called longs) will need to pay a funding fee to the sellers (called shorts).
This encourages more sellers to enter the market and bring down the BTC perpetual’s price closer to the market rate. The vice versa happens when the perpetual contracts are trading below the underlying asset’s market rate.
Please note that the funding fee you pay or receive will depend significantly on the size of your open positions and the underlying crypto asset.
Hence, if you open highly leveraged long positions, you may pay a substantial funding fee to the shorts.
Example of perpetual contract
Let’s use the earlier example to understand the funding fee better. You place a market order to buy a perpetual futures contract of 1 BTC at $30k, and it’s filled up by a seller almost instantly. In this case, you’re long on BTC, and the seller is short on it.
Assuming that the current funding rate is 0.01% and is paid out every 8 hours, you’ll need to pay the seller a funding fee = 0.01% x your position value for your open contract at the next payout interval.
If, after 20 days, the BTC spot rate has increased to $38k, you can close your contract. However, you’ll need to continue paying the funding fee to the seller for those 20 days (if the funding rate stays positive).
As this contract has no expiry date, you can also keep it open and close it when you want.
Why use perpetual contracts?
- Perpetual contracts allow users to hold on to their leveraged positions for longer durations without expiring. This gives them the flexibility to exit their trades at the right time.
- Many crypto traders use perpetual contracts to earn passive income through funding fees. They open leveraged short positions in the perpetual futures market and then open equally-sized long positions in the spot market to offset their risk.
Where to trade perpetual contracts
Bybit
Launched in 2018, Bybit has become the preferred derivatives exchange for over 2 million crypto traders.
You get to pick from a wide range of USDT, USDC, or crypto-backed perpetual contracts, including BTC, ETH, ETC, SOL, and BNB.
The offered leverage can go up to 100x. The funding fee is paid every 8 hours at 00:00 UTC, 08:00 UTC, and 16:00 UTC. It’s calculated based on the following formula:
Funding Fee = Position Value x Funding Rate
Position Value = Quantity of Contract / Mark Price.
The calculation of Funding Rate is as follows:
Funding Rate (F) = Premium Index (P) + clamp (Interest Rate (I) – Premium Index (P), 0.05%, -0.05%)
More details can be found here.
Pros of Bybit
- Copy trading feature to replicate successful traders’ actions
- Good variety of USDT, USD and crypto-backed perpetual contracts
- Up to 100x leverage
Cons of Bybit
- Not available in the United States
- No trading volume-based fee discounts
- No KYC, thus potential exposure to bad actors
Check out our Bybit review, or sign up through our referral link using our referral code DEFIRATE.
Binance.com
Binance is the largest crypto derivatives exchange in the world by trading volume and open interest at the time of writing.
You can open perpetual contracts for many cryptocurrencies (50+), including popular ones like BTC, ETH, MATIC, ADA, and more.
The margin can be in the form of USDT/BUSD stablecoins or crypto assets. The offered leverage can go up to 125x, and the funding fee is paid out every 8 hours at 00:00 UTC, 08:00 UTC, and 16:00 UTC. The funding fee and rate are calculated as follows:
Funding Amount = Nominal Value of Positions x Funding Rate
Nominal Value of Positions = Mark Price x Size of a Contract
Funding Rate (F) = Average Premium Index (P) + clamp (Interest Rate) – Premium Index (P), 0.05%, -0.05%)
You can learn more about it here.
Pros of Binance.com
- Up to 125x leverage
- Relatively lower trading fees than competitors
- High liquidity because of high trading volume
Cons of Binance.com
- Requires strict KYC completion to unlock all features
- Binance Futures isn’t available in the US
- Binance has been facing regulatory troubles
Check out our full Binance review, or sign up through our referral link.
dYdX
dYdX is a US-based decentralized crypto derivatives exchange that delivers the efficiency and features similar to a centralized trading platform.
It uses Starkware’s StarkEX layer 2 scaling solution to allow crypto perpetuals trading in a non-custodial and trustless environment.
The platform features 30+ crypto perpetual markets, and you’re allowed up to 20x leverage to trade perpetuals on margin.
The funding fee is paid out in USDC hourly, and the funding rate changes every 8 hours. Here’s how it’s calculated:
Funding Fee = Size of the Position (S) x Index price for the market supplied by Oracle (P) x Funding Rate (R)
Funding Rate = (Premium Component / 8) + Interest Rate Component
More info can be found here.
Pros of dYdX
- Decentralized, trustless and non-custodial trading environment
- Low fees and no Ethereum gas fees on perpetuals
- High-performance perpetual trading interface
Cons of dYdX
- Low leverage as compared to competitors
- No KYC, thus higher exposure to risks
- No support for fiat currencies
Check out our full dYdX review, or sign up through our referral link.
FTX.com
Founded in 2019, FTX.com is a centralized cryptocurrency exchange which offers a wide range of crypto trading products, including perpetuals, futures, and other derivatives.
Like its peers, FTX.com offers all popular crypto assets in its perpetual markets. You can place perpetual trades with leverage of up to 20x.
The collateral margin can be stablecoins and other crypto assets like USDT, CUSDT, ETH, BTC, BCH, LTC, and more.
The funding fee is paid out on an hourly basis. And the funding rate is calculated using this formula:
Funding Rate = Position Size x TWAP of ((Future Market Price – Index) / Index) / 24
Where TWAP = 1-hour time–weighted average price
Pros of FTX.com
- Comprehensive KYC to safeguard from bad actors
- Low fees as compared to competitors
- Allows a wide range of crypto as margin
Cons of FTX.com
- Low leverage as compared to rival platforms
- US residents can use only the US-specific platform
- Trading interface has room for improvement
Sign up through our referral link using our referral code BESTBONUS.
How people make money off perpetual contracts
People make money through perpetual contracts by speculating on crypto price movements without dealing with the complexity of sending/receiving actual crypto assets.
Combined with leverage, skilled traders can make potentially larger profits with perpetuals, though losses are equally magnified.
Arbitraging is another commonly used method to make money from perpetual contracts. Here’s how it works:
Arbitrage
Due to inefficiencies of the crypto market, there are typically differences between a crypto asset’s spot price and perpetual contract price on different exchanges. This offers an arbitrage opportunity to traders.
Here are two commonly used arbitrage methods:
- The first method uses the convergence of basis. Let’s assume that BTC perpetual is selling for $31k on Exchange A and the BTC spot price on Exchange B is $30k. You can buy 1 BTC in the spot market and then sell it in the perpetual. You can liquidate your position in both markets as the prices converge. If the convergence point is $28k, selling 1 BTC in spot will incur a loss of $2k; however, closing your perpetual contract at that price will earn $3k. Your overall profit will be $1k.
- The second method is based on the funding fee. Let’s assume the funding fee for BTC perpetuals is +0.1% on Exchange A. This means that longs will pay shorts 0.1% in every payout interval. Let’s also assume that the BTC spot and contract price are identical on both Exchanges A and B. You can buy $20k worth of BTC in Exchange B’s spot market and sell a $20k BTC perpetual contract on Exchange A. This will earn you a funding fee on Exchange A, while offsetting/hedging any losses through the spot trade on Exchange B. You’ll continue earning this yield if the funding rate stays positive.
Pros of perpetual contracts
- No expiration
- Different hedging possibilities
- Profit potential even in stable markets
Cons of perpetual contracts
- Funding rate costs
- Amplified losses if using leverage
- Not ideal for beginners
Pros of perpetual contracts
No expiration
Perpetual contracts offer the flexibility of closing one’s position at the most profitable time. You can set up multiple contracts to better manage your risks without constantly keeping track of every contract’s expiry.
Different hedging possibilities
Perpetual contracts allow traders to use different hedging possibilities to offset their losses in the spot market. Traders can even benefit from the funding fee and earn passive yield.
Profit potential even in stable markets
As perpetual contracts can be set up with leverage, you stand to make significant gains. If you trade with 100x leverage, even a small price change can lead to significant gains. However, the losses are also equally bigger.
Cons of perpetual contracts
Funding rate costs
Apart from the risk of volatile price movements, traders must also pay a premium on their open long positions. The same holds true for shorts in a bear market.
Amplified losses if use leverage
Anyone who uses leverage for their perpetual trades must deposit a certain amount of initial and maintenance margin. This investment can get wiped out (liquidated) quickly if you take significantly large positions.
Not ideal for beginners
Learning perpetual contracts can be particularly steep for someone starting in the crypto trading industry and even for people new to futures. Rushing into perpetual contracts trading without enough knowledge and experience can lead to major losses.
Final thoughts on perpetual contracts
Perpetual contracts are a cleverly-designed derivative variant that has become quite popular.
A perpetual contract offers the best of both futures and spot markets, allowing traders to use leverage without worrying about expiring futures contracts.
However, as with any leveraged trade, perpetual contracts have the inherent risk of losing one’s entire initial investment.
This risk is higher if you take on significant leverage. Therefore, you must do your due diligence and understand the risks before trading perpetuals.
Frequently asked questions
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Can you terminate a perpetual contract?
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How long can you hold a perpetual contract?
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What is the difference between perpetuals and futures?