The funding rate is a fundamental aspect to take into account when trading perpetual futures contracts. This article looks at funding rates in detail. Meanwhile, to learn more about how to trade futures on BTSE, take a look at this complete guide.
Funding Rate: How It Works
BTSE is among a small number of exchanges offering both traditional and perpetual futures contracts. While traditional futures have specific expiration dates, perpetual futures are more similar to spot trading because they do not expire until you close your position.
For this reason, additional tools are required to make sure that the price of futures contracts remains fairly close to the index price – this is where the funding rate plays a part in perpetual futures contracts.
The Role of Funding Rates
Futures contracts are derivatives that derive their prices from an underlying asset. Therefore, exchanges like BTSE need to make sure that the price of the derivative and the price of its underlying asset does not differ too much from each other.
This is why futures exchanges use funding rates, which are constantly recalculated to identify differences and minimize them – on BTSE, the funding rate is charged or received every hour.
In simple terms, the funding rate is the amount of money paid to or taken from open positions, in order to reduce the differences between prices:
- If the price of the contract is too high compared to the price of the underlying asset, BTSE pays short positions;
- On the contrary, if the price of the contract is too low in comparison with the asset, the platform takes a certain amount of capital from long positions.
Of course, the funding rate is calculated by taking into account the positions of all traders.
To better understand this point, let’s analyze the image below.
As we mentioned in our BTSE Futures user interface guide, each trader can personalize their platform interface. The funding rate is typically shown above the chart of any perpetual futures trade.
Keep in mind that the funding rate can be positive or negative for both long or short positions. As we are addressing traders in general, clarifying this point is important to fully understand what happens according to the funding rate:
- When the funding rate is positive, in essence, it means the price of the perpetual contract is higher than the mark price, thus, traders who hold long positions would pay for short positions.
- On the contrary, when the funding rate is negative, this indicates that the price of the perpetual contract is below the mark price. Therefore, traders who short pay for the long positions. Of course, every trader pays according to the size of their open positions.
The funding rate is an important aspect of perpetual futures contracts. This mechanism allows contract prices to be fairly in line with the spot market even when contracts have no expiration, helping to avoid large divergences from the index price in the long run.
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