Perpetual contracts can not only hedge risks, but also explain in detail how to use capital rates to arbitrage

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The combination of the perpetual market and the spot market is the most basic and commonly used strategy.

Written by: Weiting Chen, Perpetual Protocol Growth Manager

Prior to this, we have learned the relevant knowledge of perpetual contract transactions several times.

This is the most traded derivative in the cryptocurrency market, reaching billions of dollars in daily trading volume.

The problem is that participating in contract transactions involves leverage. Leveraged trading is risky-especially when the market is contrary to your predictions. You may be liquidated, resulting in loss of assets.

But… did you know? There is a relatively safe way to obtain a considerable rate of return while maintaining market neutrality.

It cannot completely eliminate risk (because you still need to trade with leverage), but it does provide a way to earn passive income from these widely traded derivatives. More importantly, you can play the role of the system, which protects you from market fluctuations.

Weiting shows you several methods, one of which has an astonishing rate of return of 32% APY.

But please pay attention! For traders, this is a fairly advanced strategy-not for everyone. Therefore, please proceed with caution.

Below we will introduce how to use the capital rate to get rich.


In today’s strategy, we will learn how to earn income through the capital rate of perpetual contract transactions while maintaining market neutrality. Before we begin, I would like to point out that because the market is dynamic, the strategies mentioned in this issue may not always be effective. It all depends on market conditions.

Having said that, after reading the book, you can still learn how to achieve market neutrality and obtain benefits from funding rates in a variety of ways.

let’s start.

  • Goal: learn how to benefit from funding rates (and more mechanisms)
  • Technique: Advanced
  • Investment: Variable-depends on how you achieve market neutrality
  • Return on investment: variable-depends on funding rate (and other sources of income)

Perpetual Contract & Funding Rate 101

If you already understand how perpetual contracts and funding rates work, please skip this section.

A perpetual contract is a derivative tool that allows you to be bullish or bearish on the corresponding asset without having to hold actual assets. If the user is bullish on the price of the underlying asset (perpetual contract price), he can open a long position with leverage; on the contrary, if he is bearish, he can open a short position.

Since it is a derivative product, the internal price of the perpetual contract is not necessarily the same as the spot price of the underlying asset. This is why if everyone opens a long position on the derivatives exchange, it will push the price of derivatives to continue to rise, which creates opportunities for arbitrageurs to open short positions to drive down prices.

Moreover, in order to further push the price of the perpetual contract (called the “marked price”) to the spot price of the underlying asset (the “index price”), derivatives exchanges usually adopt a method called “funding rate payment”. Mechanism to provide incentives, so that more traders take (bullish or bearish) the choice of the lesser side.

The working method of fund rate payment is as follows:

In a given time interval (usually every eight hours), the derivatives exchange calculates the difference between the time-weighted average price of the marked price (ie, “TWAP”) and the TWAP of the index price. If the difference is greater than 0 (funding rate> 0), it means that there are too many long positions on the exchange.

Conversely, if the difference is negative (funding rate <0), the long position holder will pay a certain funding fee from his margin to the short position holder, and vice versa.

Summary:

  • When the mark price> index price, the long side pays the fund cost, and the short side gets the fund cost
  • When the marked price <the index price, the longs get funding costs, and the shorts pay the funding costs

Factors that affect the direction of fund rate payment

Two things can affect the direction of funding rates:

  • The overall market sentiment of the asset
  • Characteristics of trading venues

The first thing should be self-explanatory-if the overall market sentiment is bullish on an asset, the funding rate may be positive because there are more longs than shorts. Otherwise, the funding rate is expected to be negative.

However, the characteristics of the trading venue also play a role in determining the funding rate.

For example, in the perpetual agreement , although the daily trading volume of the ETH/USDC perpetual market exceeds 10 million USDC, the prices of derivatives are often lower than the spot prices in centralized exchanges, as shown in the following figure:

Perpetual contracts can not only hedge risks, but also explain in detail how to use capital rates to arbitrage

My explanation for this phenomenon is that the perpetual agreement uses the constant product curve of x * y = k within the virtual automated market maker (vAMM) to determine the price of the perpetual contract, which is derived from the exchange under the order book model Compared with product transactions, more funds are needed to drive market prices.

Therefore, traders are more conservative on the perpetual agreement platform-because if traders buy too aggressively during a bull market, they may have to wait longer for the price to rise to the level where they usually expect to close their positions.

Therefore, since the ETH/USDC market was launched on the perpetual agreement, the funding rate has been negative most of the time. On the contrary, in exchanges that use the order book model such as FTX, the funding rate of the same asset is usually positive during the bull market (see the table below for details).

Perpetual contracts can not only hedge risks, but also explain in detail how to use capital rates to arbitrage

How to generate revenue from funding rates (and more mechanisms)

Before delving into the following guidelines, it is important to understand what a market neutral strategy is.

There is a good definition on Investopedia : a market neutral strategy is an investment strategy that attempts to profit from the rise and fall of prices in one or more markets, while trying to completely avoid a certain form of market risk.

For today’s strategy, the market-neutral strategy we will implement is to create a portfolio of positions whose profits and losses offset each other so that investors can (mainly) profit from capital expenses.

Let’s start with a simple example.

Strategy #1: Perpetual Market & Spot Market Combination

The easiest way to achieve market neutrality is to establish a position in the perpetual market, the direction of which is to obtain the funding fee, and to establish a position in the opposite direction in the spot market.

For example, because the perpetual market’s funding costs on the perpetual agreement are usually negative, you can open a long position through perp and open a short position in the corresponding asset of the equivalent position on a margin trading platform such as Fulcrum or dYdX.

Remember: when the funding rate is negative, the shorts pay the funding costs to the longs.

If the underlying asset is too new to be listed on any margin trading platform, you can try your luck on Cream Finance, which is similar to Aave or Compound, but its listed assets are more diverse. If you can, you can also sell the borrowed assets on Uniswap to offset your long position in the perpetual market.

Conversely, if the funding rate in the perpetual market is generally positive, you can open a short position in that market and purchase the underlying asset in a spot market such as Uniswap.

For those who want to implement this strategy: Remember to consider transaction fees, interest rates and gas fees for margin trading.

Strategy #2: Two perpetual markets with opposite funding rate directions

As mentioned earlier, the funding rate on perpetual agreements is usually negative, while the funding rate on order book exchanges is usually positive. In order to profit from this situation, traders can open positions on their respective platforms with the same position size but in the opposite direction of long and short.

For example, at the time of writing, the hourly funding rate of the ETH/USDC perpetual market on the perpetual agreement is -0.0039%, which means that if you hold a long position at the end of the hour, you will receive funding fees.

At the same time, on dYdX, the 8-hour funding rate for the same market is 0.0689%, which means that if you hold a short position within the funding rate settlement time, you will receive funding fees.

Perpetual contracts can not only hedge risks, but also explain in detail how to use capital rates to arbitrage

According to this strategy, you can open a long position of 5 ETH on the perpetual agreement with a leverage of 2 times, and at the same time open a short position of 5 ETH on dYdX with a leverage of 2 times. Assuming that the funding rates of the two agreements remain unchanged, then you can accumulate a total of 0.03% of remuneration from your corresponding positions every 8 hours, that is, the APR is 32.85%.

đź’ˇNote from the author: I have used a lower leverage here because I want to reduce the risk of liquidation.

Strategy #3: Perpetual Market & Quarterly Futures Market Combination

For a perpetual market where the funding rate is always paid in the same direction, you can establish a position to obtain funding fees in this market, and open a corresponding position under the same underlying asset market in the opposite direction in the quarterly futures market. In this way, you can maintain market neutrality and still receive funding costs.

đź’ˇTraditional futures contracts have no funding rate mechanism.

For example, in November last year, when the Filecoin perpetual market and quarterly futures market were launched on FTX, due to its high fully diluted valuation, the funding rate of the perpetual contract has been negative since the first day.

If we can go back in time, we can open a long position of 100 FIL in the perpetual market and open a short position of 100 FIL in the futures market on December 28.

There may be a question that keeps echoing in your mind: “When should I close my position?” Well, it depends on your strategy. However, I will consider closing the position when the following two situations occur: 1) When the direction of payment of funds costs has changed for a period of time, that is, the market sentiment has changed; or 2) When the quarterly futures expire.

However, at present, this strategy can only be executed on centralized exchanges, because there are very few perpetual markets on decentralized exchanges, even those with the richest collection of perpetual markets in decentralized exchanges On perpetual agreements, there are only less than twelve markets.

But I think the situation will be greatly improved this year because:

  1. New agreements such as SynFutures are building traditional futures markets on the chain
  2. The perpetual agreement will introduce a market creation function, allowing anyone to add trading pairs, just like on Uniswap.

Strategy #4: Perpetual Market + DeFi Gainer

If you have enough creativity, in addition to funding rates, you can also find more income methods.

Given that the funding rate on perpetual agreements is usually negative, you can combine long positions on perpetual agreements with short positions on Synthetix to achieve market neutrality.

With this combination, you can get:

  • The cost of funding from your long position on the perpetual agreement,
  • Up to 110% rebate of transaction fees (in PERP) from transaction mining plans, and
  • SNX rewards for your short positions on Synthetix.

Let me use the previous example to explain the strategy in detail.

Nowadays, the funding rate of the ETH/USDC perpetual market based on the perpetual agreement is -0.0039%, so you should open a long position to obtain funding fees.

Suppose you open a long position of 1 ETH here with a leverage of 2 times. Similarly, low leverage can reduce the risk of liquidation of positions.

Then, you go to the Synthetix exchange to obtain 1 iETH, which is back-tracking the price of ETH (back-tracing means that if the price of ETH goes up by 1 USD, the price of iETH goes down by 1 USD).

Perpetual contracts can not only hedge risks, but also explain in detail how to use capital rates to arbitrage

đź’ˇYou need sUSD to trade on the Synthetix exchange. If you need to buy, Curve is a good choice.

Once you receive your iETH, your combined position should be market-neutral-if ETH goes up by $1, then your long profit on the permanent agreement is $1, which offsets the $1 loss of iETH on Synthetix. In the last step, you need to go to Synthetix’s income page to pledge your iETH tokens, so that you will receive pledge rewards on SNX. The current annualized income of iETH pledge exceeds 100%.

Perpetual contracts can not only hedge risks, but also explain in detail how to use capital rates to arbitrage

Overview

There are many ways to use funding rates to get returns while maintaining market neutrality.

Whether it is implementing a more basic strategy such as a combination of perpetual market + spot market, or trying to take advantage of the dual advantages of funding rates on different platforms, or even using other DeFi protocols such as Synthetix, it can bring you benefits.

However, it is more important to realize that some of these strategies are only feasible under certain market conditions (for example, the direction of payment of capital rates), and such market conditions are not always the same.

In any case, once you have a deep understanding of how the funding rate works and the underlying market dynamics, you can usually find a way to take advantage of the funding rate.

Just please be cautious, because there are risks in leveraged trading, and you may still be liquidated!

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