March 29, 2024

Funding rate as a trading signal

The downward trend continues for many weeks and months. Funding rates are back negativeVareas of important support, and many crypto twitter influencers point outon this circumstance as a signal for a market reversal. You're not sure how to feel about this… Is there any truth to this at all? In this post, Ben Lilly, Senior AnalystJarvis Labs, shows what the data says about it, anddemonstrates an example of a statistically profitable strategy based on funding rates alone, working in any market trend and requiring no other data points.

When opening a trade, you may immediately ask yourself how long to keep it open: are you expecting a short-term rally or a real market reversal?

And the answer is "when how, depends on the circumstances" -not the most accurate possible. There is actually a signal in the funding rates. But you need to understand how to profit from it - that's what distinguishes a successful trader from the rest.

And today I will try to parse this signal and show you the alpha that can be statistically extracted from funding rates data. But first, let's deal with the term.

What is the funding rate

The funding rate is defined as the costholding an open position in perpetual futures. The rate can be neutral, negative or positive. Each exchange may have its own nuances, but in general, the funding rate is updated several times a day and for the bitcoin market it tends to be positive values, at which long positions pay short ones.

When due to demand for futures contractsmore longs are opened, the buying side has to pay extra to the sellers for opening opposite short positions. This ensures that the price of perpetual futures is linked to the spot price of bitcoin. In such a situation, funding is described as positive.

If the volume of short positions (sales) onperpetual futures exceeds the volume of longs (purchases), the opposite happens: sellers pay extra to buyers for opening buy positions. In such a situation, funding is described as negative.

This is a good indicator of the averagepositioning of traders in the market: with a positive funding rate, the market is dominated by an optimistic, “bullish” mood, and vice versa. And the more pronounced the expectations become, the more the funding rate can deviate from the equilibrium values.

During periods of euphoric demand, every eighthours can rise significantly above 0.2-0.3%, which in terms of the year gives more than 300%. That is, more than 300% of the cost of a long for a year of holding it at such a rate. However, thanks to the mechanism of reversion to the mean, the funding rate is regularly adjusted, resetting to neutral values. This is the basis of the strategy of buying at a negative funding rate and selling at a positive one.

And so we decided to check if there is an easy way to extract reproducible profit from this strategy - alpha.

First test

In the test, we proceeded from the fact that a trader opens a long position at the moment when the funding rate becomes negative and holds the position for 48 hours.

The chart below shows the maximum drawdownfor such a strategy within a 48-hour period. The naked eye can see the predominance of negative bars, which means that the strategy is not only losing, but also risky.

Maximum drawdown for longs on negative funding when holding a position for 48 hours

But what if we shorten the position holding time,say before 8, 16 or 24 hours? The rest of the parameters are the same: buy BTC at the moment when the funding becomes negative, and sell when the rate becomes positive.

The graph below shows the test results forhistorical data for each BTC long with a negative funding rate and holding it within the suggested time frames. The Y-axis shows the percentage of profit / loss, the X-axis shows the number of occurrences.

It can be seen that for scalping with a limit of 8, 16and 24 hours, the profitability chart is in positive territory for much more time. At the same time, profits of 5% or more were often realized. This means that it makes sense to take a closer look at this…

Profitability of the strategy based on the funding rate for 8-, 16- and 24-hour periods

Important detail:In our tests, we used the funding rate from Binance, which resets every 8 hours. And, for example, on FTX it is reset at an interval of 1 hour. We recommend understanding how your exchange resets its funding rate before trying out a strategy like this.

Let's dig a little deeper

For those who are interested in how these strategies perform over time, below are some backtesting charts.

It is worth noting that this strategy can be used in both bull and bear markets. That is, it does not require an additional model that would report the current market trend.

The green line is just buy and holdread: just BTC price. The yellow line is the 8 hour strategy, the orange line is the 16 hour strategy and the red line is the 24 hour strategy. All three strategies have been generating positive returns since summer 2021 regardless of the market trend.

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Winner - 8 hours strategy. But how big is the gap from the 16-hour. runner-up strategy?

Here are the stats for the 8-hour clock:

  • coefficient Sharpe: 0.84
  • time in market: 14%
  • total return: 227.67%
  • maximum drawdown: -14.77%

Statistics for 16-hour clock:

  • coefficient Sharpe: 0.7
  • time in market: 20%
  • total return: 186.36%
  • maximum drawdown: -19.67%

So, the 8-hour strategy is more efficient, which can also be seen from the better capital efficiency. In this backtest, capital is only in the market for 6 out of 24 months.

It is noteworthy that in March 2020 theselong-only strategies showed the most profit (check out the heatmaps for both strategies). For the 8-hour strategy, the return in March 2020 was more than 31%. No leverage, only spot.

Moral of the story&#8230; What we see here is that the funding rate is actually a reliable market indicator. But it all comes down to how to use it.

Financing rates do not give a reliable signalfor a period of 24 hours or more, but work reliably for shorter-term strategies. So while funding rates may not signal a massive reversal in the market trend as many analysts would like, they should not be ignored. This indicator is capable of generating profits. The main thing is to know exactly how to extract it.

 

BitNews disclaim responsibility for anyinvestment recommendations that may be contained in this article. All the opinions expressed express exclusively the personal opinions of the author and the respondents. Any actions related to investments and trading on crypto markets involve the risk of losing the invested funds. Based on the data provided, you make investment decisions in a balanced, responsible manner and at your own risk.

Based on sources: blog post and thread by Jarvis Labs