Analysis: Combining these indicators, we find a local bottom for Bitcoin prices

Original title: "Analysis: Is there an inevitable connection between high Bitcoin futures funding rates and the plunge?"

Futures contract volumes have grown significantly over the past year, as evidenced by the growth in total open interest, which is the total number of contracts that have not been delivered. Open interest has risen 450% in six months from $3.9 billion to $21.5 billion currently.

Sometimes traders believe that high or low funding rates and surging open interest indicate a bullish market, but as Cointelegraph has previously explained, this is not the case. This post will take a quick look at funding rates and how traders can interpret funding rates for perpetual futures contracts.

Funding rate can be used as an indicator of bull and bear markets

Perpetual futures contracts are typically charged an embedded rate every 8 hours to ensure that there is no imbalance in trading risk. Although the open positions of buyers and sellers are matched at any time, their leverage may be different.

When longs use more leverage, they will be the ones paying the fees. Therefore, this situation is interpreted as bullish. Conversely, when shorts use more leverage, resulting in negative funding rates, the opposite is true.

Whenever traders use high leverage, analysts point to the risk of cascading liquidations. While this is true, this can last for weeks and sometimes deleveraging happens on its own. Therefore, as the data shows, such indicators should not be used to predict local tops.

Bull markets usually create positive funding rates when buyers are overly excited. However, this situation still creates a huge storm for shorts, because a 5% price correction will force longs using 20x leverage to close their positions. These orders may put pressure on prices, causing a 10% drop in prices, followed by a cascade of liquidations.

For this reason, experts and analysts often cite excessively high funding rates as the primary cause of cascading liquidations during market declines, even though funding rates can remain abnormally high during bull markets.

Funding rate can find local bottom

Bitcoin futures funding rate and USD price Source: Bybt

Note how the funding rate reached 0.15% or even higher every 8 hours in February when local tops were not forming. This rate is equivalent to 3.2% per week, which is a bit burdensome for traders holding long positions. Therefore, trying to use this indicator to time market peaks will rarely yield good results.

On the other hand, the Bitcoin price bottoms on January 27 and February 28 were formed when the funding rate was low. These moments showed that traders were reluctant to use leverage to go long and also proved their lack of confidence.

Low funding rates must be viewed in context with the market

While this indicator may be helpful in determining if a local bottom has formed, it certainly should not be used by itself as the funding rate will typically level out after any significant price correction.

Additionally, sustained high funding rates can attract arbitrage traders who sell perpetual futures and simultaneously buy monthly contracts. Therefore, this indicator should be used with caution.

To confirm investors’ distrust of open longs, we should monitor the premium of monthly contracts, or “basis”. Unlike perpetual contracts, those futures with fixed expiration dates have no funding rate. Therefore, their prices will be very different from those of regular spot exchanges.

OKEx quarterly futures basis source: Skew

By measuring the price difference between futures and the regular spot market, traders can judge how bullish the market is. As long as buyers are overly optimistic, the annualized premium (basis) of quarterly futures contracts will reach 20% or more.

Combining these indicators, we can find the local bottom of Bitcoin price

On the other hand, when the indicator shows a local bottom, it usually means that traders’ confidence is growing. Therefore, buyers using low leverage can get better “confirmation” when the perpetual contract funding rate is low.

By combining the perpetual contract funding rate with the monthly contract basis, traders will be able to better read market sentiment. Similar to the popular "fear and greed" indicator, traders should buy when others are skeptical.

As shown in the above figure, this situation usually occurs when the funding rate is lower than 0.05% per 8 hours and the quarterly contract basis hits bottom.