Futures trading has increased significantly over the past year, as evidenced by the general rise in open interest rates. Open interest is the total number of contracts outstanding, and that number has grown from $3.9 billion to $21.5 billion in six months, an increase of 450%.
Sometimes traders assume that a high or low funding rate and rising open interest indicates a bull market, but as Cointelegraph has explained, this is not the case. This article provides an overview of the coverage ratio and how traders interpret this metric when trading open futures contracts.
The refinancing rate may be either increasing or decreasing
Perpetual contracts have an embedded rate that is typically calculated every eight hours to ensure there is no lag in currency exposure. Although the open interest of buyers and sellers is always the same, their leverage may differ.
When long positions require more leverage, they pay the price. Therefore, this situation is interpreted as bullish. The opposite happens when shorts use more leverage, resulting in a negative coverage ratio.
Whenever traders use high leverage levels, analysts point out the risks of cascading liquidation. That’s true, but the situation can evolve for weeks, and sometimes the removal of the mid-level happens naturally. Therefore, such an indicator should not be used to predict local peaks, as the data show.
Bull markets usually trigger positive financing rates when buyers are overly enthusiastic. Yet this creates the perfect storm for short sellers, as a 5% price correction will force long positions with 20x leverage to unwind. These orders can put pressure on the price, cause a 10% drop and lead to a new cascade of liquidations.
Therefore, experts and analysts often point to excessive funding rates as the main cause of cascading liquidations when the market turns negative, although funding rates may remain abnormally high during bull markets.
Financing rate can indicate local lower limit
BTC futures financing price at the US dollar price. Source: Bybt
It should be noted that in February, when no local summit had been formed, the funding rate for the eight-hour session was 0.15% or more. This rate equates to 3.2% per week and is somewhat uncomfortable for traders with long positions. Therefore, attempts to calculate market peaks using this metric rarely yield good results.
On the other hand, the price of BTC reached its lowest level on the 27th. January and 28. February occurred during periods when the funding ratio was low. These moments show that traders were not willing to use long leverage, and this indicates a lack of trust on their part.
Low funding rates should be viewed in the context of
Although this indicator can help determine if a local bottom has formed, it should never be used alone, as the support price usually disappears after any sharp price correction.
In addition, longer periods of high funding will attract arbitrageurs who will sell perpetual futures and buy monthly contracts. Therefore, this measure should be used with caution.
To confirm the investors’ lack of confidence in opening long contracts, the monthly contract premium, called the base premium, should be tracked. Unlike contracts of indefinite duration, fixed-term contracts do not involve a financing rate. Consequently, their price will be very different from that of the usual cash trade.
OKEx 3-Month Futures Basis. Source: Crouch.
By measuring the difference in cost between futures contracts and the regular cash market, a trader can assess the degree of market upside. If buyers are too optimistic, the three-month futures contract will trade at an annual premium of 20% or more (base rate).
A combination of indicators can indicate the local bottom price of BTC
On the other hand, when the indicator marks a local low, it usually means that the trader’s confidence is gaining. Thus, in a scenario where the funding rate for perpetual contracts is low, there is better confirmation that buyers are using low leverage.
By combining the financing rate of perpetual contracts with a monthly contract basis, the dealer has a better understanding of market sentiment. Like the famous fear and greed indicator, traders should buy when others are suspicious.
This scenario typically occurs when the refinancing rate is below 0.05% for eight hours and at the bottom of the 3-month futures range, as shown in the chart above.
The views and opinions expressed herein are those of the author and do not necessarily reflect those of Cointelegraph. Every investment and every stage of trading involves risk. You should do your own research before making a decision.
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