In the case of delivery contracts, the further the delivery date and the greater the price fluctuation, the more the contract price may deviate from the spot price. However, on the delivery date, it will be forcibly settled based on the spot price, so the price will eventually return. Unlike delivery contracts with scheduled delivery, perpetual contracts can be held indefinitely. A mechanism is needed to ensure that the contract price is consistent with the spot price, and this mechanism is called the funding rate mechanism. If the price is bullish for a period of time and there are many long positions, it will lead to the perpetual price being higher than the spot price. In such cases, the funding rate is generally positive, meaning that the long side has to pay fees to the short side based on their positions, and the larger the deviation from the market, the higher the rate. This makes the price tend to fall. Trading long positions in perpetual contracts is essentially borrowing money to leverage, and there is a cost to using capital, so most of the time, the rate is generally around 0.01%. The funding rate is collected every 8 hours or 4 hours, so the perpetual price often closely follows the spot price.
Shorting perpetual contracts, going long on spot, and holding for the long term can theoretically be immune to fluctuations in the cryptocurrency’s price and earn long-term positive funding rate income.
The rate can go as low as -2%. If it occurs once, the loss is equivalent to the profit of 200 times at a rate of 0.01%. The solution is to diversify and hedge, meaning that if you hedge against more than 30 positions at a time, the loss from one cryptocurrency will only account for a small portion. In addition, when encountering this situation, it is necessary to close positions in advance. However, due to transaction fees and closing costs, you should not close positions just because the rate is negative. Generally, rates below -0.2% can be closed to avoid this. Generally, when there is a negative rate, the perpetual price is lower than the spot price, and the negative spread allows for potential profits after deducting transaction fees.
Generally, a positive rate means that there is a premium for perpetual contracts over the spot market. If the premium is high, there may also be profits from the premium’s regression. However, the strategy always holds positions for the long term, so it does not pursue this part of the profit. It is important not to open positions with high negative spreads. However, in the long run, the issue of spread changes can be ignored.
Contract Liquidation Risk
Due to diversified hedging, this risk is much smaller. Taking 5x leverage in perpetual contracts as an example, unless the overall price rises by 20%, there is a possibility of liquidation. And because of spot hedging, there is no loss at this time. Just transfer funds by closing positions or ensure that additional margin can be added at any time. The higher the perpetual contract leverage, the higher the capital utilization rate, and the higher the risk of contract liquidation.
Long-Term Bear Market
In a bull market, rates are mostly positive, and many cryptocurrencies have an average rate that can exceed 2%. Occasionally, there are very high rates. If the market turns into a long-term bear market, the average rate will decrease, and the probability of large negative rates will increase, reducing profits.
The fee extraction strategy is generally low-risk, has a large capital capacity, is relatively stable, and has low profits. It is suitable for those who pursue low-risk arbitrage opportunities. If your trading funds are idle, consider running this strategy, which can provide higher returns than the exchange’s financial products.
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