Bitcoin Faces Volatility Rise as Futures Market Shows Signs of Overheating

A metric from bitcoin's perpetual futures market suggests some traders may have become overleveraged during the recent rally to above $18,000.

The average level of the "funding rate" across major exchanges has risen sharply from 0.023% to a five-month high of 0.087% in the past 48 hours, according to data source Glassnode.

"Rising funding rates have in the past been associated with a larger portion of the market utilizing leverage via perpetuals," Matthew Dibb, CEO of Stack Funds, told CoinDesk. "If we see continued overleveraging in the derivatives market, bitcoin will be increasingly volatile in the short term."

Calculated every eight hours, the funding rate in effect reflects the cost of holding long positions. The metric is used by exchanges offering perpetuals (futures contracts with no expiry) as a mechanism to balance the market and guide perpetual prices toward the spot price.

The funding rate is positive (or longs pay shorts) when perpetuals trade at a premium to the spot price. As such, a very high funding rate is widely considered a sign of leverage being excessively skewed to the bullish side, or overbought conditions, as noted on Twitter by market analyst Joseph Young.

In such situations, a pullback or consolidation can trigger an unwinding of longs, leading to a deeper drop and a pick up in price volatility. "The high funding rate can cause somewhat of a 'shakeout' due to increasing margin liquidations," Dibb said. Holding longs at elevated costs is attractive only if a bull run continues without pauses.

Historical data validates Dibb's analysis of the market.

Bitcoin's rally from July lows near $9,000 ran out of steam near $12,400 on Aug. 17 as the average funding rate surged from 0.008% to 0.078%. The cryptocurrency fell back to $10,000 in early September.

Similarly, the recovery rally from March lows below $4,000 ran out of steam near $10,000 in early June with a sudden rise of the funding rate to 0.123%.

While the funding rate has risen in the past 48 hours, it's still short of the peak seen in June.

Further, the uptick may have been partly fueled by liquidity providers hedging sell positions in the spot market by buying long positions in the futures/perpetuals, according to Patrick Heusser, a senior cryptocurrency trader at Zurich-based Crypto Broker AG. In other words, the latest rise in funding rates may not be entirely retail-driven.

Also read: Crypto Long & Short: 4 Metrics That Show How the Current Bitcoin Rally Is Different From 2017

Nevertheless, the metric's rise calls for caution on the part of the bulls, as it represents overleveraged or overbought conditions. "It's a first indication that leveraged [traders] are starting to shoot over the target," Heusser told CoinDesk.

Bitcoin's implied volatility is already rising with the one-month gauge currently hovering at 77%, the highest level since July 8, according to data source Skew. That means the options market is pricing in a rise in volatility over the next four weeks and looks to be preparing for a temporary disruption to the steep rally.

The top cryptocurrency by market value is currently trading close to $18,650, having tested dip demand with a drop to levels below $18,000 over the weekend.

Disclosure: The author holds small positions in bitcoin, litecoin, XRP, cardano and tron.