As a trader, you need to understand the time cycles for paying/receiving funding fees and how funding rates fluctuate over time.
Author: The Black Swan
Compiled by: Deep Tide TechFlow
In the cryptocurrency perpetual contract market, price deviations often occur, and traders can profit from these pricing errors.
“Cash and Carry Trade” is a classic profit strategy that allows traders to gain returns from the difference between perpetual contract prices and spot prices.
Funding Rate Arbitrage — Earn 25%-50% in Passive Income Annually through Cash and Carry Trade?
In the cryptocurrency perpetual contract market, price deviations often occur, and traders can profit from these pricing errors. “Cash and Carry Trade” is a classic strategy specifically targeting the differences between perpetual contract and spot prices, allowing traders to easily achieve profits.
Through this strategy, traders can perform arbitrage operations on centralized exchanges (CEX) and decentralized exchanges (DEX) without incurring high fees. Specifically, you can establish a long position in the spot market while selling the corresponding perpetual derivatives. When the market overall leans towards long (i.e., when the price premium is high), you can gain additional income through the funding rate. If this sounds a bit complicated, don’t worry, I will explain it in a simple way (ELI5).
What is the Funding Rate?
The funding rate is a periodic fee that traders need to pay or receive based on the difference between the perpetual contract price and the spot market price. The size of this rate depends on the skew of the perpetual contract market and the degree of deviation of the perpetual contract price relative to the spot market.
In simple terms, when the trading price of the perpetual swap contract is higher than the spot price (i.e., premium), the deviation on trading platforms like Binance, Bybit, dYdX, or Hyperliquid becomes positive, and long traders need to pay the funding rate to short traders. Conversely, when the trading price of the perpetual swap contract is lower than the spot price (i.e., discount), the deviation becomes negative, and short traders need to pay the funding rate to long traders.
What we need to do is essentially mimic the operation method of Ethena Labs: go long on ETH in the spot market while shorting ETH perpetual contracts. But the difference is that we will operate it ourselves and choose the assets we are interested in (hint: it doesn’t have to be ETH).
If you don’t want to read the previous content, I will try to explain it simply.
Let’s take Ethereum as an example; we want to go long on ETH (preferably staked ETH).
We can take stETH (annual yield of 3.6%) as an example while shorting $ETH in the perpetual contract market (for example, on Binance or Bybit).
When we simultaneously take equal amounts of long and short positions in ETH, our portfolio is in a “Delta Neutral” state. This means that regardless of how ETH’s price fluctuates, we will not incur losses or profits due to price changes.
The “Delta Neutral Strategy” is an investment method that avoids market price fluctuation risks by balancing long and short positions. For example, if I simultaneously open a long position of 1 ETH and a short position of 1 ETH at the same price, then regardless of how the market price changes, the total value of my portfolio will not be affected (ignoring fees).
In this strategy, our income comes from two parts: ETH staking income and funding rate income.
The funding rate is a mechanism used to adjust the difference between the perpetual contract price and the spot market price. Its function is similar to the interest cost in spot margin trading, ensuring that the price of perpetual contracts does not deviate from the price of the spot market by adjusting the capital flow between long and short parties.
The settlement of the funding rate is as follows:
The funding fee is a fee settled directly between buyers and sellers, usually at the end of each funding interval. For example, with an 8-hour funding interval, the funding fee is settled at 12 AM, 8 AM, and 4 PM UTC.
On decentralized exchanges like dYdX and Hyperliquid, the funding fee is settled hourly, while Binance and Bybit settle every 8 hours.
When the funding rate is positive, long holders pay the funding fee to short holders; when the funding rate is negative, short holders pay the funding fee to long holders (this usually occurs in a bull market, which I will explain in detail later).
Only traders who hold positions at the time of funding settlement will pay or receive the funding fee. If positions are closed before the funding settlement, no funding fee will be incurred.
If a trader's account balance is insufficient to pay the funding fee, the system will deduct it from the position margin, which will bring the liquidation price closer to the mark price, thus increasing the liquidation risk.
Let’s analyze the funding rate shown in the image. The funding rate calculation mechanisms used by perpetual contract exchanges on different chains may vary slightly, but as a trader, you need to understand the time cycles for paying/receiving funding fees and how funding rates fluctuate over time. Here’s how to calculate the annualized return (APR) based on the funding rate in the image:
For Hyperliquid:
0.0540% * 3 = 0.162% (1-day APR)
0.162% * 365 = 59.3% (1-year APR)
As you can see, Binance has a lower funding rate, with an annualized return of 31.2% (calculated in the same way). Additionally, there is an arbitrage opportunity between Hyperliquid and Binance. You can go long on ETH perpetual contracts on Binance while shorting ETH perpetual contracts on Hyperliquid, thus obtaining a return difference of 59.3% and 31.2%, which is 28.1%. However, this strategy also carries some risks:
Fluctuations in the funding rate may cause the long funding fee on Binance to be higher than the short funding fee on Hyperliquid, leading to losses.
Since the long position is not spot, you cannot earn staking rewards, which will reduce overall returns.
But the advantage of this method is that using perpetual contracts for long and short operations allows you to leverage, thus improving capital efficiency. It is recommended to create an Excel sheet to compare the returns and risks of different strategies to find the one that suits you best.
When the funding rate is positive (as in our example), long traders need to pay the funding fee, while short traders will receive the funding fee. This is crucial because it provides the basis for us to design a Delta Neutral strategy to profit from the funding rate.
Spot and Futures Arbitrage
One of the simplest and most common strategies is “Cash and Carry Trade,” which involves simultaneously buying a spot asset and selling the same amount of perpetual contracts. Taking ETH as an example, the trading strategy is as follows:
Buy 10 ETH/stETH spot (worth $37,000)
Sell 10 ETH perpetual contracts (worth $37,000, can be done on dYdX, Hyperliquid, Binance, or Bybit)
At the time of writing, the trading price of ETH is about $3,700. To execute this strategy, traders need to try to complete the buy and sell operations at the same price and quantity simultaneously to avoid “unbalanced risk” (i.e., market fluctuations causing the two sides' positions to not fully hedge).
The goal of this strategy is to earn a 59% annual return through the funding rate, regardless of whether the market price rises or falls. However, while this return looks very attractive, traders need to be aware that the funding rates may vary across different exchanges and assets, which can affect the final returns.
Your daily funding fee income can be calculated using the following formula:
Funding Fee Income = Position Value x Funding Rate
Using the current ETH funding rate of 0.0321% as an example, let’s calculate the daily income:
Daily Funding Fee Income: 10 ETH x 3,700 = $37,000 x 0.0540% = $20, settled 3 times a day, totaling $60.
Daily Staking Income: 10 ETH x 1.036 = 0.36 ETH per year / 365 = 0.001 ETH per day, equivalent to $3,700 x 0.001 ETH = $3.7.
Thus, the total daily income is $60 + $3.7 = $63.7. For some, this may be a decent income, while for others, it may seem trivial.
However, this strategy also faces some risks and challenges:
Difficulty in simultaneously opening long/short positions: When you check the spot price and perpetual contract price of ETH on Binance or Bybit, you will find that there is usually a price difference between the two.
For example, when I wrote this article, the spot price was $3,852, while the perpetual contract price was $3,861, with a price difference of $9.
How should you operate? Try using a small amount of capital, and you will find it almost impossible to perfectly match long and short positions.
Should you go long first and wait for the price to rise before going short, or should you go short first and wait for the spot price to drop before buying? Or should you balance the long and short positions through dollar-cost averaging (DCA)?
Trading Fees: Opening and closing positions incur fees. If your holding time is less than 24 hours, the fees may lead to losses.
Low Capital Rebalancing Risk: If your long and short positions are equal, but the market fluctuates significantly (e.g., ETH doubles to $7,600), the short position may incur deep losses while the long position profits significantly. In this case, it may lead to an imbalance in your account's net worth, even forcing liquidation.
Liquidation Risk: Depending on the available funds in your account on the exchange, if the short position encounters extreme market conditions (e.g., ETH price surges), it may trigger liquidation.
Funding Rate Fluctuations: The funding rate fluctuates with market changes, which may directly affect your returns.
Difficulty in simultaneously closing positions: The challenges faced when closing positions are similar to those when opening positions, and it may not be possible to precisely match long and short positions, leading to additional costs or risks.
Centralized Exchange Risks: If Binance or Bybit encounters issues, such as bankruptcy or withdrawal restrictions, your funds may be at risk. This is similar to the risks of smart contract vulnerabilities in DeFi.
Operational Error Risks: If you are not familiar with perpetual contracts, you need to be particularly careful. Market order operational errors may lead to extreme price fluctuations, and you may execute at a very poor price. Additionally, opening or closing a position requires just a click of a button, and operational errors may significantly impact the trading results.
By the way, you can also explore options trading. This method may be simpler and can save you some costs :)
I just wanted to show you how to try Ethena Labs' trading strategy.
That’s all for today.
See you on the order book, anonymous friend.
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