Summary
Given the unique attributes of the bitcoin futures market, one can construct trading strategies to generate risk-free profits by entering a long spot, short futures, delta-neutral position.
In pursuing these trades, our backtesting analysis shows a strategy of converting accrued BTCs immediately rather than holding on to them generates superior risk-adjusted return. The strategy can also be applied to other crypto assets with perpetual futures, such as ETH, SOL, etc.
The unique attributes of the bitcoin futures market often serve as fertile ground for implementing risk-free trading strategies. In this report, we analyze two different strategies involving funding fee arbitrage, aiming to identify the most optimal approach.
Perpetual Futures
Perpetual futures, often referred to as perpetuals, are derivatives that enable traders to speculate on the future value of an asset. They resemble standard futures, but lack a predefined expiry date, allowing them to be held indefinitely.
Without a proper mechanism, the price of a futures contract may deviate from the spot price. In a traditional futures contract, the settlement of the futures price at expiration aligns with the spot price, with arbitragers playing a crucial role in preventing price divergence.
Since perpetuals don’t have an expiry date, they have a different mechanism to prevent price divergence. Below is a brief description of how the mechanism works:
They are periodically settled (typically every 8 hours) through a mechanism known as the funding rate.
If the perpetual price is higher than the spot price (meaning the perpetual is at a premium), the funding rate becomes positive. As the gap increases, so does the rate. In such scenarios, long position holders pay a fee to short position holders.
Conversely, if the futures price falls below the spot price (meaning the perpetual is at a discount), the funding rate turns negative, and holders of short positions pay a fee to those with long positions.
Under no arbitrage conditions, the funding rate remains slightly positive when prices are level. For example, the default funding rate on the Binance exchange is 0.01% for 8 hours. Refer to this study, Fundamentals of Perpetual Futures by He et al., for more detail.
Exploring Funding Fee Statistics
In a bull market, the funding rate usually remains positive and often sharply increases as a result of widening price divergence. On the other hand, in a bear market, the funding rate often becomes negative, as illustrated in Figure 1 and Table 1.
Figure 1. BTC price vs funding rate in the Binance COIN-M market
Source: Binance, Presto Research
Table 1. Funding rate stats
As shown in Table 1, the annualized average funding rate is positive and notably high, especially in 2021 and 2024, though it appears mediocre during the 2022 bear market period. Given these statistics, trading strategies can be designed to generate risk-free profits by entering a delta-neutral position. Two types of strategies will be evaluated.
Strategy 1: Simple Holding
A simple holding arbitrage strategy in the Binance COIN-M market involves purchasing a certain amount of BTC on the spot market and simultaneously shorting an equivalent amount of the perpetual contract. The BTC acquired on the spot market serves as the collateral for the short position. The funding fee is then accumulated in BTC. The profit and loss (PNL) at time $t$ of this strategy can be broken down as follows:
, where and are self-explanatory, comes from the change in the difference between the spot and perpetual prices, and results from the price movement of the accrued BTC.
The outcome of deploying this simple strategy with 1,000,000 USDT (30.268269 BTC) on February 1, 2021, is illustrated in Figure 2 and Table 2.
Figure 2. Simple holding arb
Source: Presto Research
Table 2. Stats of simple holding arb
Because the profits are accumulated in BTC, this strategy is subject to significant maximum drawdown (MDD), and consequently, its Sharpe ratio is not particularly appealing.
Strategy 2: Holding Immediate Sell of Accrual
A straightforward way to stabilize the profits involves immediately selling the BTC accrued from the funding fee. The result of this simple strategy can be seen in Figure 3 and Table 3.
Figure 3. Holding and immediate sell of accrual arb
Source: Presto Research
Table 3. Stats of holding and immediate sell of accrual arb
This strategy’s annualized return is less than that of Strategy 1, but it boasts a much higher Sharpe ratio and significantly reduced MDD, making it highly attractive. Concerns might arise about the accrual frequently becoming negative, potentially triggering liquidation. However, with the margin ratio consistently above 99%, liquidation would not have been triggered at any point during the simulation period.
Conclusion
The two simple funding fee arbitrage strategies we have assessed are not only applicable to BTC, but can also be extended to other crypto assets such as ETH, SOL, etc. Using the full quantity of spot holdings to back the short positions in the perpetual market is not capital efficient. By appropriately managing the margin, the remaining amount might be deposited in lending markets for additional earnings, thus enhancing returns. Another enhancement could involve entering the arbitrage position when the funding rate exceeds a certain threshold and exiting when the rate turns negative. As the basis tends to decrease when the funding rate is negative, there is potential to profit from these basis changes. This concept is subject to further research.