In the past I've shared some articles that cover the theory of derivatives contracts and metrics, but in this post I'll share a more detailed explanation of how to interpret derivatives data and how to use it to your advantage for trading.
I strongly recommend reading my previous posts before reading this one if you're not too familiar yet with this type of data and analysis yet.
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The example I'll be using for this exercise is the BTC rally from roughly $17000 to roughly $22000 from January 8 to January 14 of 2023.
The indicators that are used for this analysis are:
Aggregated open interest of linear perpetual swap contracts. I mainly look at linear contracts because they're the most actively traded derivs contracts in crypto right now. I only look at perps and not regular futures because most of the speculation and directional positioning happens on perps, not regular futures.
Aggregated and open interest weighted predicted funding rates. Regular funding is also useful to look at, but I focus mostly on predicted since it more accurately and more so in real time reflect how traders are positioning. It has to be OI weighted because a contract with a billion dollars in outstanding contracts is obviously more relevant than a small market with only a million dollars in open interest, for example. I include all the most actively traded perps in this, both linear and inverse, because it's OI weighted anyway.
Aggregated liquidations for linear perps. Looking at liqs for inverse contracts is fine too, but once again, linear perps are the most popular so they're more important.
Aggregated CVD for linear perps and for the spot market. No extra comment needed.
Because aggregated data lumps everything together you might sometimes miss something very interesting that's happening. Looking at data of individual markets is more work of course, but it can be worth it sometimes. It all depends on how much effort you want to put in...
I'll give you a quick tip.
At the time of writing (18 JAN 2023) the most important derivs markets for BTC are:
Binance linear BTC/USDT
Binance linear BTC/BUSD
Binance inverse BTC/USD
Bybit linear BTC/USDT
Bybit inverse BTC/USD
OKX linear BTC/USDT
OKX inverse BTC/USD
Less actively traded, but still relevant, markets are the Bitmex XBT/USD inverse perp and the dYdX BTC/USD linear perp. The Deribit BTC/USD inverse perp also often has a decent amount of open interest but that market isn't where your typical degen comes to speculate so I tend to ignore that data or I at least look at it through a different lens.
To stay up to date on which contracts hold the most weight I suggest taking a look once in a while at the CoinGecko markets page and check which contracts have the most OI and volume: CoinGecko
Just know that A LOT of exchanges fake their stats cough Kucoin, MEXC, BinX, Bitget, ... cough.
Now let's dive into it.
We're flat, we got no positions open, and we're looking for an opportunity. So we wait for the market to show its hand and then we strike. During that initial pump on the 8th of January we get our first couple clues. There's a small pump and simultaneously open interest collapses. If you read my previous post about derivatives data basics you already know that when price goes up and OI goes down it's reasonable to assume that shorts are covering their positions, either voluntarily or forced through
stop-losses or liquidations.
More evidence that this OI build up is mostly short biased can be found in the funding rate. While the OI is increasing previous to the pump on the 8th, the predicted funding rate constantly dips below baseline. A 0.01% rate per 8 hours is considered "baseline". That's because most exchanges have a "clamp" that the funding rate snaps to as a default when the difference in the price of the perp and the price of the spot index is neglectable. Because the funding rate often dips below baseline we can infer that there's quite a bit of shorting going on.
The liquidations give us another clue. During that relatively small pump a bunch of short liquidations happened. Now we can more confidently conclude that what happend during that pump is in fact short covering and we assume that the market is generally short biased.
Still don't feel like jumping into a long? Fine, me neither actually. Let's play it safe and wait for even more evidence that it's a good time to go against the grain.
After that pump on the 8th the predicted funding rate quickly goes into negative territory while open interest starts increasing again. There's a mini dip where the funding rate tries to reset and snap back to baseline, but it doesn't get a chance to do that. In fact, it quickly goes deeply negative again on rising open interest. We now know pretty confidently that bears aren't learning their lesson. They're being stubborn.
It's time to go long. But why exactly?
Anywhere in the blue box highlighted on the chart above you should be opening longs in my opinion.
That's where you go long because the derivs market is aggressively shorting, but something keeps pushing the price higher anyway. Because of this shorts are almost immediately underwater no matter where they opened their position. On top of that the funding rate is going negative, so they're paying money just so they could keep their position open and lose more money because the market refuses to crash. This is fuel, this is what causes fireworks. Mentally make a guess of where the average shorter probably opened their position and wonder how they would be feeling. How brave do you think they are? Where did they put their stop-loss and how close is the price to it?
Once these shorts get squeezed it creates even more buying power, lifting the market higher. That's why we go against the grain when we figure out that one side of the active speculators are in trouble.
Another, but more subtle, hint that the market is directionally short is the CVD.
The price is rising the entire time, but the CVD is relatively muted. It's still going up a little bit, mostly because of shorts that are still getting stopped out (short closing turns into buying). Especially considering that open interest is rising fast you would expect the CVD to pump too, if it were mostly market longing that's happening.
The CVD is in this case a bit more difficult to use effectively and it's also imperative to understand that the CVD only shows one half of the story. If you want to add this to your analysis you'll also have to look at the orderbooks to fully understand what's going on. Read my post about the cumulative volume delta indicator if you're new to this.
Anyway, from here on out it gets really fun.
Boom, to no surprise another pump happens and open interest nukes again. We also see a bunch of liquidations, even more than before. Clearly shorts are getting destroyed. But the fun doesn't stop because OI immediately tries to climb again. There's no reason yet to close our long.
Boom, another pump, another OI nuke and more liquidations. Bears are getting slaughtered here. But what's really crazy is that once again, OI immediately tries to climb and funding is going negative!
These bear don't want to learn, or maybe they enjoy donating money to the market. We'll gladly take that money, the long stays open.
Boom! This is clearly the grand finale. A big pump happens, and we see a massive liquidation cascade and an epic collapse in open interest. Every single short that got opened during the entire rally just got forced out of their position. It's time to close the long and bank the profits. Why now? I'll get back to that in a second.
First and foremost it's important to understand that we kept our long open the whole time because there were signs throughout entire rally that bears just kept fading the trend. That's perfect, that's fuel, that's what you want to see and what you want to trade against. The whole point of analysing this type of data is so that you can figure out how people are positioned, and subsequently which side of the trade (long or short) is "offside". Offside market participants are participants who are badly positioned. In this example that was the bears. The side that's offside is at risk of getting trampled. This is why we counter trade the people who are offside.
A quick summary.
The way we analysed the market is by:
Looking at the open interest and how it reacts to price movement.
Analysing predicted funding. Again, the trend and how it moves in relation to price is important.
Looking at liquidations.
Analysing the CVD.
Using common sense.
That last point can't be understated.
It's not enough to just look at some indicators and go "positive funding bearish, negative funding bullish" for example. You have to understand what these metrics actually represent, how they work and what kind of impact they have. Funding for example is a type of interest that market participants actually have to pay depending on how they're positioned. This has a real impact on their risk management. But if the market is nuking hard for example, and funding is negative, who cares? In that case shorts are in fat profit so a negative funding rate wouldn't matter all that much. You have to take a step back and think about these things.
I also mentioned earlier that it's good practice to make a mental image of what it would look like if you were short. Where would you put your stop-loss? What's funding looking like? What's the price action doing? If the open interest is very high and price keeps going up, shorts will get run over and that causes an even more explosive pump.
This is all part of the common sense aspect of it.
Finally we get to the last part of our trade, but equally important as entering the trade: exiting.
I know that this post is a little long, and with your modern day distorted Tik Tok attention span this is a real challenge, but this final part is crucial. We're almost there.
How would you decide to exit the trade? Would you look at some horizontal lines on a candlestick chart and then pick an arbitrary level? There's nothing wrong with that, I also do some traditional technical analysis as a very basic foundation to form some initial ideas of where price might go, but this isn't how I decide to close a trade.
Just like I enter a trade based on how the derivs data is looking, I also close my trade based on how the derivs data is looking.
When that last big pump happened we saw three things:
A massive liquidations print.
The funding rate skyrocketed for the first time.
Open interest got absolutely obliterated.
About the explosive funding rate: this is normal, it happens when there is a big short liquidation event. When shorts close they turn into "buys"; forced buying that is. When a lot of forced buys happen at the same time price slices through the perp orderbook and disconnects from the spot market for a while. Eventually it'll most likely gravitate back to baseline, but initially it spikes. When that spike happens it tells you that a massive blowout happened.
Open interest nuking really is key here. It tells you that every single position that got opened during the rally got closed out. Shorts got liquidated or stopped out, and longs hit their targets. Once this happens and open interest is dead, it's definitely time to exit the trade if you haven't already.
Why? The thesis played out.
We entered in the first place because we saw that there was a big short build up.
We kept the position open because we saw that bears were stubborn and kept re-shorting.
So once, literally, all of those positions close there's no more reason to be long because you're not trading against the offside counterparty anymore. The counterparty got liquidated.
This means that the "obvious" trade has played out, and from this point on it's much less clear what's going to happen. It's also very typical after such an explosive pump that time is needed for the dust to settle. The market needs to lick its wounds and people need some time to think and open positions again. So typically price goes sideways for a while after such a big liquidation cascade.
Trading is mostly about doing nothing.
A good trader needs to be patient and calmly and quietly observe. Once the derivs data paints a clear picture of who's offside, you take advantage of that and trade against them.
To further expand on this point that trading is mostly about doing nothing, I want to share this beautiful poker quote: "if you can't spot the sucker in the room, then you're the sucker".
This also applies to trading. With the type of analysis discussed in this post we try to figure out who the suckers are, or who's "offside", and then we trade against them. If you have no idea who the suckers are, it's best to stay flat because otherwise chances are pretty high that you end up being the sucker.
You made it lads and lasses.
Hopefully it's a bit more clear now how you can use this data to your advantage.
Until next time!