Perpetual Futures Contracts In the Crypto: What Is That and How Do They Work?
Perpetual Futures in Crypto & Investing
In 2023, cryptocurrency exchanges offer a wide range of trading instruments satisfying the needs of almost any trader. Perpetual futures contracts are among the most popular products. Under certain scenarios, this tool offers better trading opportunities compared to spot and options trading.
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 instrument. Other types of derivatives also include options and swaps.
A futures contract is an agreement between two parties. The buyer promises they will buy (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 of an asset. For instance, with bitcoin perpetual futures, traders 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, very similar to futures contracts, are futures swaps. The difference is in the expiration date, as well as in the funding fee.
Perpetual swaps, or “perps”, 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.
What Is a Perpetual Contract?
Another name for perpetual swaps is perpetual futures contracts. Trading perpetual swap contracts on a cryptocurrency exchange does not include the real trade of one 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).
How Do Perpetual Futures Work?
An important feature of crypto perpetual futures contracts is that they track the spot price of the cryptocurrency, trading very close to this price. Thus, the main mechanism that makes perpetual contracts possible is financing. At certain hours, traders make payments to each other based on their open positions. The difference between the price of the perpetual contract and the spot price determines who pays and who receives the payment. Thus, when the funding rate is positive, traders with long positions pay shorts, and when the funding rate is negative, shorts pay longs.
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
Since you can trade cryptocurrencies with leverage using perpetual contracts, it is important to understand what margin is.
What Is the Initial Margin?
Initial margin is the minimum amount you need to have in order to open a position. It is a kind of collateral for your trading position.
What Is the Maintenance Margin?
Maintenance margin is the minimum amount you must have in your margin account in order for your trading position to remain open.
Perpetual Futures Terms
Also, when trading perpetual futures, you need to know and understand a few basic terms.
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 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?
Leverage can significantly increase the returns in trades. But at the same time, it amplifies losses. There is a chance of losing all capital, which may also create problems for other market participants.
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.
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.
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.