Perpetual Futures Contracts In Crypto: What Is That and How Do They Work?
Perpetual Futures in Crypto & Investing
As we navigate through 2023, it's clear that cryptocurrency exchanges have evolved to offer a wide range of trading instruments, catering to the needs of virtually any trader. Among these instruments, perpetual futures market has gained significant favor within the crypto community. Largely, the popularity is attributed to the inherent flexibility of the perpetuals.
Like the traditional futures contracts, crypto futures enable holders to hedge against potential risks related to future price fluctuations of the base asset. What sets them apart is that the cryptocurrency futures contracts are based on crypto assets. Perpetual futures, unlike conventional futures which have a specific settlement date, allow purchasing or selling the base crypto at a non-specified date in the future.
If you are a novice trader, this article will help you to better understand the nuances of perpetual futures trading. We will break down the concept of the perpetual cryptocurrency futures contracts and outline their benefits.
What Is a Futures Contract?
Futures contracts are a type of derivative financial instrument. Other types of derivatives include options and swaps. Trading futures on a cryptocurrency exchange does not include the real trade of one crypto asset for another. There is a so-called cash settlement, which implies the execution of the transaction solely in the equivalent monetary value of the contract (without a physical exchange of assets).
Essentially, a futures contract is an agreement between two parties. The buyer promises they will purchase (and the seller will sell, respectively) an asset at a specified time, in a specified amount, at a predetermined price. Such contracts can also be traded on the secondary market. They guarantee the settlement of the transaction.
Futures contracts allow traders, investors, and commodity producers to speculate on the future price movement of an asset. For instance, with bitcoin perpetual futures, you can trade bitcoin at a future price that is negotiated at the time of the contract purchase. Futures trading enable margin trading with leverage. Leverage increases the amount of potential gains or losses at the moment of buying or selling the asset.
What Are Perpetual Swaps?
Another type of cryptocurrency derivatives are perpetual swaps, or “perps”. They are similar to futures contracts in that they allow traders to buy or sell the underlying asset in the future. But they have one key difference: perpetual swap contract has no expiration date.
These contracts simulate the effect of holding a spot position over the long term by "swapping" a contract for another every so often, typically every 8 hours. Hence, they are referred to as “swaps”. This is when the funding rate is applied, which is a mechanism used to tether the contract price to the spot price. We’ll explain in more detail how this mechanism works below.
What Is a Perpetual Contract?
“Perpetual contract” is just another name for “perpetual swap”. Both terms refer to a type of futures contract that doesn't have an expiry date, allowing traders to hold their positions indefinitely. So in essence, perpetual swaps and perpetual contracts are the same instrument, allowing traders to speculate on the future asset price (like Bitcoin or Ethereum) without worrying about the expiration of the contract.
How Do Perpetual Futures Work?
An outstanding feature of crypto perps is their tendency to mirror the spot price of the base cryptocurrency. Typically, it results in trades occurring very close to this reference price. The consistency between the contract price and its base asset's market price is maintained through the funding rate mechanism. This system conducts routine financial swaps between traders who are engaged in long and short positions.
The question is, how it is determined who pays whom? The direction of the payment depends on whether the perpetual futures price or the spot value is higher. When the perpetual futures price surpasses the spot value, it indicates positive funding rates. As a result, traders with short positions are rewarded with a funding fee. Conversely, in a scenario where the perps' price is lower than the spot value (i.e., negative funding rates), long traders earn a fee.
Thus, a typical perpetual trade goes as follows. If a trader believes that the BTC will increase in price, they open a long position. When the price rises to a target level, the trader closes the position. However, if the price moves in an unfavorable direction for the trader, if there is sufficient margin, the trader can hold the position until the price recovers.
Margin Requirements for Perpetual Futures
Perpetual futures, as we've noted earlier, enable traders to utilize leverage. It essentially involves a loan from the broker or exchange, facilitating greater trading positions than the trader's initial capital would allow. While leverage may potentially magnify profits, it’s important to remember that it also carries the risk of intensifying losses.
Leverage trading is intertwined with the concept of margin. Grasping the fundamentals of margin, as well as comprehending the margin requirements, is crucial for perpetual futures traders. Let's delve deeper into these concepts.
What Is the Initial Margin?
Initial margin refers to the minimum sum you need to maintain in your account in order to open a trading position. Serving as a form of collateral, it essentially backs up your leveraged exposure in the market. Its size depends on the level of leverage provided by the exchange. Leverage is basically a loan given to boost potential returns from a trade. It's crucial to note, however, that a high level of leverage escalates risk proportionally.
Normally expressed as a percentage, the initial margin depends on the utilized leverage and the specific policies of the exchange. For example, a platform demands a 1% initial margin. If you wish to open a position equivalent to 1 Bitcoin, then according to the exchange’s requirements you must deposit 0.01 Bitcoin as the initial margin, assuming Bitcoin's price is taken as the unit price.
What Is the Maintenance Margin?
The maintenance margin represents the necessary amount of collateral you must hold on your margin account to sustain your open trading position. This benchmark is typically referred to as the maintenance margin requirement and is expressed as a percentage. Another concept tightly connected with it is the margin ratio, i.e. the proportion of your account equity to the utilized margin.
If market fluctuations lead to a decrease in your margin balance and consequently your margin ratio dips below the established requirement, there's an increased likelihood of your position being forcefully liquidated. As such, managing your account to prevent breaching this pivotal level is of utmost importance in leveraged trading.
Trading on CEX vs DEX
Trading crypto perpetual futures on centralized exchanges (CEX) and decentralized exchanges (DEX) come with distinct differences due to the inherent structures of these platforms.
A centralized exchange is governed by some centralized authority or registered business. Such exchanges often offer more liquidity, faster transactions, and easy conversion between cryptocurrencies and fiat currencies. Additionally, they provide customer support, which can be vital for new traders. However, as CEXs accumulate a lot of users’ funds, they become very attractive targets for hackers and malicious actors. Moreover, they require users to complete a Know Your Customer (KYC) process, which may not appeal to those desiring anonymity.
On the other hand, a decentralized exchange operates without a central authority, instead using blockchain technology to facilitate trades directly between users. DEXs offer greater privacy as they often do not require KYC checks, and they provide users with full control over their funds, reducing the risk of loss from exchange hacks. However, DEXs often have less liquidity and slower transaction speeds compared to CEXs. Also, they can be more difficult to use, especially for less experienced traders.
When it comes to trading crypto perpetual futures, these differences translate into varying experiences. Centralized exchanges may provide a smoother, more intuitive trading experience with higher liquidity, making it easier to enter and exit positions. They may also offer higher leverage options. However, decentralized exchanges give traders more control over their funds, more privacy, and potentially lower fees, but with typically lower liquidity and potentially more complexity in terms of interface and operation.
As always, each trader should weigh these differences against their individual needs, preferences, and risk tolerance before choosing where to trade.
Perpetual Futures Terms
Also, when trading perpetual futures, you need to know and understand a few basic terms.
What Are Entry and Exit Prices?
The entry price, as its name suggests, is the price at which a trader initiates a position in the futures market. If they predict an uptrend, they go long, buying at a lower price with the expectation that the price will rise.
On the other hand, if they anticipate a downtrend, they go short, selling at a higher price with the expectation that the price will drop. The exit price, in contrast, is the price at which a trader chooses to close their position, locking in their profits or cutting their losses. For long positions, the goal is to exit at a higher price than the entry, and for short positions, it's to exit at a lower price.
The gap between the entry and exit price, considering the number and value of contracts, dictates the trader's profit or loss. It's a delicate balance, amplified by leverage, requiring a meticulous strategy grounded in careful analysis and an acute awareness of the inherent risks in the highly volatile cryptocurrency market.
What Is Liquidation?
In the context of futures trading, liquidation refers to the forced sale of losing positions. It is carried out in order to prevent the balance from falling to negative values. Thus, if the value of your collateral falls below the supporting margin, the funds in your futures trading account may be liquidated. The point at which this occurs is known as the liquidation price.
The likelihood of liquidation depends primarily on the amount of leverage. If a minor correction occurs in the market, the liquidation is highly unlikely with the low leverage. But high leverage, under the same circumstances, can quickly deplete a trader's collateral. This will lead to liquidation and loss of funds.
What Is the Funding Rate?
As we discussed above, one of the primary mechanisms of perpetual futures is financing. The funding rate at which payments are calculated consists of two components: the interest rate and the premium. The interest rate is set by the platform. The premium depends on the difference in price between the crypto perpetual contract and the mark-to-market price.
What Is the Mark Price?
The mark price is the target price for a perpetual futures contract. The mark price is used to prevent unfair and unnecessary liquidations that can occur when the market is highly volatile.
The mark-to-market price consists of two components: the Index Price and the Moving Average (MA). The Index Price is the aggregate price of the major spot exchanges, weighted by their relative volume. At the same time, a moving average helps smooth out price data over a period of time by creating a constantly updated average price.
What Is PnL?
Profit and loss (PnL) is a certain value that shows the difference between a trader’s profits and losses for a certain period. When the trader has open positions on perpetual contracts, their PnL is “unrealized”. When the trader closes positions, the unrealized PnL becomes a “realized” PnL (partially or fully).
The unrealized PnL for open-ended futures is calculated with the following formulas:
- For Long: Unrealized P/L = (Futures Mark Price - Initial Futures Buying Rate) * Position Size;
- For Short position: unrealized P&L = (Initial Futures Mark Rate - Futures Mark Price) * Position size.
Remember that the unrealized PnL depends on market movements and fluctuates due to constant rate changes.
What Is the Insurance Fund?
An insurance fund is a kind of safety cushion that protects the trader from unwanted losses. The fund is used to prevent “socialized losses” — a situation where the income of profitable traders is used to cover the losses of insolvent traders.
The exchanges with a large capitalization insurance fund cover deficits on liquidated accounts. Thus, traders do not have to worry about socialized losses.
What Is Auto-deleveraging?
Auto-deleveraging (ADL) serves as a safeguard employed by certain cryptocurrency exchanges within the futures market to manage risk and bolster market stability. When a trader takes a leveraged position, they essentially borrow capital to amplify the potential return of their investment. For instance, 100x leverage will increase potential profit a hundredfold. However, it's crucial to note that the potential for losses increases at the same rate.
Should a trader's position swing towards excessive risk, reaching the liquidation price, and the exchange is unable to liquidate the position at the bankruptcy price due to extreme market volatility, the ADL system is triggered.
Auto-deleveraging (ADL) restricts especially aggressive-risky traders, who use the “it's all or nothing” principle. With large capital and high leverage, such traders can seriously undermine the overall financial structure of the cryptocurrency market.
Auto-deleveraging is accomplished by automatically adjusting leverage. It typically reduces leverage levels and possibly liquidates profitable trades to rebalance the financial system of the exchange or broker. The priority of deleveraging is calculated based on the amount of profit and the amount of leverage. Traders with higher profit and higher leverage are the first to be liquidated.
Auto-deleveraging is the last resort. This measure is taken only when the insurance fund cannot cover the positions of a bankrupt client.
In Conclusion
Many traders prefer perpetual cryptocurrency futures because of their convenience. Also, they allow you to trade cryptocurrencies without owning them. And because of the leverage, they offer more potential profit in the short term compared to the spot market. However, one must keep in mind that trading perpetual futures involves a lot of nuances, which makes it more complicated and risky compared to spot trading.
FAQ
Why Do Users Trade Futures Contracts?
Futures contracts are a convenient tool that allows traders to hedge their risks associated with future changes in the price of a cryptocurrency. The leverage allows traders to make large profits using less capital.
Can Perpetual Futures Contracts Expire?
A perpetual futures contract is a type of futures contract that has no expiration date.
What Are Perpetual Futures in Crypto?
A perpetual futures contract is a type of cryptocurrency derivative which is an agreement between two parties to sell or buy an asset (cryptocurrency) at a fixed price on a predetermined future date. For example, BTC perpetual futures allows selling or buying BTC at a set price and date.
How Do Perpetual Futures Work in a Few Words?
The market for open-ended futures contracts is similar to the marginal spot market, and the price of open-ended futures is linked to the spot price of the underlying asset through the funding rate.
Let's imagine that a user has opened a position in the BTC/USDC Linear Contracts market. As long as the position is not liquidated or closed manually, the user can hold the position indefinitely without any delivery date requirements.
The lack of an execution date means that even when prices do not move in the trader's favor, he does not have to lock in a loss. Instead, with sufficient Maintenance margin, they can hold positions open and wait for prices to start playing in his favor again.
What Are Bitcoin Perpetual Futures
Bitcoin perpetual futures are contracts for selling/buying BTC at a certain price in the future, with no expiration date.
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.
