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

This article is from Chain News, authored by Weiting Chen.

Previously, we have learned about perpetual contract trading several times.

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

The problem is that participating in contract trading involves leverage. Leverage trading is risky—especially when the market moves against your predictions. You may get liquidated, resulting in asset loss.

But… did you know? There is a relatively safe way to achieve considerable returns while remaining market neutral.

It cannot completely eliminate risk (as you still need to engage in leveraged trading), but it does provide a method to earn passive income from these widely traded derivatives. More importantly, you can play a role in the system, which makes you less affected by market fluctuations.

Weiting has shown you several methods, one of which has achieved an astonishing 32% APY.

But be careful! For traders, this is a fairly advanced strategy—not suitable for everyone. So please proceed with caution.

Below, we will introduce how to get rich using funding rates.

In today's strategy, we will learn how to earn returns through the funding rates of perpetual contract trading while maintaining market neutrality. Before we begin, I want to point out that since the market is dynamic, the strategies mentioned in this issue may not always be effective. It entirely depends on market conditions.

That said, after reading this, you can still learn how to achieve market neutrality and earn from funding rates in various ways.

Let's get started.

• Objective: Learn how to earn from funding rates (and more mechanisms)
• Skill Level: Advanced
• Investment: Variable - depends on how you achieve market neutrality
• Return on Investment: Variable - depends on funding rates (and other sources of income)

1. Perpetual Contracts & Funding Rates 101

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

A perpetual contract is a derivative that allows you to speculate on the price of an underlying asset without holding the actual asset. If a user is bullish on the price of the underlying asset (the perpetual contract price), they can open a leveraged long position; conversely, if bearish, they can open a short position.

Since it is a derivative, the internal price of a perpetual contract does not necessarily match the spot price of the underlying asset. This is why if everyone is opening long positions on the derivatives exchange, it can drive the derivative price up continuously, creating opportunities for arbitrageurs to open short positions to push the price down.

Moreover, to further align the price of the perpetual contract (referred to as the "mark price") with the spot price of the underlying asset (the "index price"), derivatives exchanges typically employ a mechanism called "funding rate payments" to incentivize more traders to take the lesser side (bullish or bearish).

The funding rate payment works as follows:

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

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

Summary:

• When the mark price > index price, longs pay the funding fee, and shorts receive the funding fee.
• When the mark price < index price, longs receive the funding fee, and shorts pay the funding fee.

2. Factors Influencing the Direction of Funding Rate Payments

Two things can influence the direction of funding rates:

• Overall market sentiment towards the asset
• Characteristics of the trading venue

The first point should be self-evident—if the overall market sentiment is bullish on an asset, the funding rate may be positive due to 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 funding rates.

For example, on the Perpetual Protocol, despite the ETH/USDC perpetual market having a daily trading volume of over 10 million USDC, the derivative prices often remain below the spot prices on centralized exchanges, as shown in the image below:

My explanation for this phenomenon is that the Perpetual Protocol uses a virtual automated market maker (vAMM) with a constant product curve of x * y = k to determine the price of perpetual contracts, which requires more capital to push market prices compared to derivatives trading on order book-based exchanges.

As a result, traders on the Perpetual Protocol platform tend to be more conservative—because if traders are too aggressive in buying during a bull market, they may have to wait longer for prices to rise to the levels they typically expect to close.

Thus, since the ETH/USDC market launched on the Perpetual Protocol, the funding rate has been negative most of the time. In contrast, on exchanges like FTX that use an order book model, the funding rates for the same asset are usually positive during bull markets (details in the table below).

Before diving into the following guidelines, it is crucial to understand what a market-neutral strategy is.

There is a good definition on Investopedia: A market-neutral strategy is an investment strategy that seeks to profit from price increases and decreases in one or more markets while attempting to completely avoid a specific form of market risk.

For today's strategy, the market-neutral strategy we will implement is to create a position combination where the profits and losses offset each other, allowing investors to primarily profit from funding fees.

Let's start with a simple example.

3. Strategy #1: Perpetual Market & Spot Market Combination

The simplest way to achieve market neutrality is to establish a position in the perpetual market that is on the side of receiving funding fees while simultaneously establishing a position in the spot market in the opposite direction.

For example, since the funding rates in the perpetual market on the Perpetual Protocol are usually negative, you can open a long position in perp and simultaneously open a short position of the same amount of the corresponding asset on margin trading platforms like Fulcrum or dYdX.

Keep in mind: When the funding rate is negative, shorts pay the funding fee to longs.

If the underlying asset is too new and has not yet been listed on any margin trading platform, you can try your luck on Cream Finance, which is similar to Aave or Compound but has a more diverse range of listed assets. If possible, 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 usually positive, you can open a short position in that market and buy the underlying asset in the spot market, such as Uniswap.

For those who want to execute this strategy: remember to consider trading fees, margin trading interest rates, and gas fees.

Strategy #2: Two Perpetual Markets with Opposite Funding Rate Directions

As mentioned earlier, funding rates on the Perpetual Protocol are usually negative, while funding rates on order book exchanges are typically positive. To profit from this situation, traders can open positions of the same size but in opposite directions on their respective platforms.

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

At the same time, on dYdX, the 8-hour funding rate for the same market is 0.0689%, meaning if you hold a short position during the funding rate settlement period, you will receive the funding fee.

According to this strategy, you can open a long position of 5 ETH with 2x leverage on the Perpetual Protocol while simultaneously opening a short position of 5 ETH with 2x leverage on dYdX. Assuming the funding rates for both protocols remain unchanged, you can accumulate a total reward of 0.03% from your corresponding positions every 8 hours, which translates to an APR of 32.85%.

Author's note: I used a lower leverage here because I want to reduce the risk of liquidation.

4. Strategy #3: Perpetual Market & Quarterly Futures Market Combination

For perpetual markets where the direction of funding rate payments is always the same, you can establish a position in that market to receive funding fees while opening a corresponding position in the quarterly futures market in the opposite direction for the same underlying asset. This way, you can maintain market neutrality while still earning funding fees.

For example, last November, when the Filecoin perpetual market and quarterly futures market launched on FTX, the funding rate for the perpetual contract had been negative since day one due to its high fully diluted valuation.

If we could go back in time, we could have opened a long position of 100 FIL in the perpetual market while simultaneously opening a short position of 100 FIL in the futures market on December 28.

You might have one question lingering in your mind: "When should I close my position?" Well, it depends on your strategy. However, I would consider closing in the following two situations: 1) when the direction of funding fee payments changes after some time, indicating a shift in market sentiment; or 2) when the quarterly futures expire.

However, currently, this strategy can only be executed on centralized exchanges, as there are very few perpetual markets on decentralized exchanges. Even on the Perpetual Protocol, which has the richest collection of perpetual markets, there are fewer than twelve markets.

But I believe the situation will greatly improve this year because:

1. New protocols like SynFutures are building traditional futures markets on-chain.
2. The Perpetual Protocol will launch market-making features, allowing anyone to add trading pairs, just like on Uniswap.

5. Strategy #4: Perpetual Market + DeFi Yield Farming

If you have enough creativity, you can find more ways to earn besides funding fees.

Given that the funding rates on the Perpetual Protocol are usually negative, you can combine a long position on the Perpetual Protocol with a short position on Synthetix to achieve market neutrality.

With this combination, you can earn:

• Funding fees from your long position on the Perpetual Protocol,
• Up to 110% rebates from trading fees (in PERP) from the trading mining program, and
• SNX rewards from your short position on Synthetix.

Let me explain this strategy in detail using the previous example.

Currently, the funding rate for the ETH/USDC perpetual market based on the Perpetual Protocol is -0.0039%, so you should open a long position to earn funding fees.

Assuming you open a long position of 1 ETH here with 2x leverage. Similarly, using lower leverage can reduce the risk of liquidation.

Then, you go to the Synthetix Exchange to get 1 iETH, which inversely tracks the price of ETH (inverse tracking means that if the price of ETH rises by $1, the price of iETH falls by $1).

You need sUSD to trade on the Synthetix Exchange. If you need to purchase some, Curve is a good option.

Once you receive your iETH, your combined position should be market neutral—if ETH rises by $1, your profit from the long position on the Perpetual Protocol is $1, which offsets the $1 loss on iETH from Synthetix. The final step is to go to Synthetix's yield page to stake your iETH tokens, allowing you to earn staking rewards in SNX. Currently, the annualized yield for staking iETH exceeds 100%.

6. Conclusion

There are many ways to leverage funding rates for returns while maintaining market neutrality.

Whether executing more basic strategies like the perpetual market + spot market combination or trying to exploit the dual advantages of funding rates across different platforms, or even utilizing other DeFi protocols like Synthetix, can yield profits for you.

However, it is more important to recognize that some of these strategies are only viable under specific market conditions (such as the direction of funding rate payments), and these market conditions are not always constant.

Regardless, once you have a deep understanding of how funding rates work and the potential market dynamics, you can usually find ways to leverage the advantages of funding rates.

Just proceed with caution, as leveraged trading carries risks, and you may still get liquidated!