Thread by @IDrawCharts

Merry Christmas, here's some genuine free alpha that you can use

Funding Rate vs Realized Drift

automation not required

most of y'all think of the funding rate like RSI; negative = oversold, positive = overbought

but you're wrong, it's way more specific

the funding rate on most exchanges is determined by taking the average difference between the perp price and spot asset price over [n] as a %, multiplied by n/24, where n is the number of hours per funding period. Sometimes + a default rate.

What this means is that over 24 hours, longs or shorts have to pay their counterparties the cost of the average premium or discount of the contract. This ensures that the contract stays roughly aligned w spot price.

but what this ALSO means...

... is that the funding rate functions as a quantitative measure of the market's expectations on price.

If I'm long and the funding rate (aka measure of perp premium) averages .0001%/h, I am betting the market will on average gain faster than that, otherwise I am -ev.

now we can extrapolate. If the average funding rate is .0001% an hour, at the beginning of every hour, we can say "price should on average be .0001% higher in one hour".

Now draw a line between the hour's opening price and that price plus .0001%.

See where I'm going w this?

Realistically, the funding rate and it's averages are often way out of line with what the market actually does, since it's a lagging indicator.

So how is this useful?

well, eventually being wrong gets expensive. If the actual performance is not matching up with the funding rate cost, the losing side of the market will be forced to start closing their positions. When they do, the funding rate and the average performance begin to converge.

By taking an average of the funding cost and an average of the market's performance over the same length of time (or a summation over time, experiment!), we can tell when one gets ahead of the other.

If they are roughly equal, the market is balanced and unlikely to trend.

But if for example, longs are paying an average of .0001% an hour but gaining an average of .002%? That's 20x their cost, they've no reason to close! Shorts will though, and this will push the premium (aka funding rate!) up, until eventually the equilibrium is reached.

We can take advantage of this comparison between position cost and position return to see whether the perp market is properly positioned.

If it is not, it represents pent-up pressure that must eventually be reconciled with the underlying spot market, often dragging it along.

Funding alone is not predictive.

But paired with analysis of realized market performance, it can help identify not only directional momentum but also the strength of that momentum, since perps have an elastic relationship with the spot market (enforced through arbitrage).

There's a lot more you can do with funding rate analysis (including some cool stat arb stuff) but this is probably the easiest aspect to understand for folks who maybe aren't used to identifying or implementing quantitative metrics and relationships.

Anyways, I figured I'd share a little alpha in the spirit of Christmas cheer

Enjoy your holiday y'all