What are perpetual futures contracts?
If you're interested in trading crypto futures contracts, you may have heard of perpetual futures contracts.
But what are they exactly?
Perpetual futures contracts are one type of crypto derivative that traders can use. Like traditional futures contracts, perpetual futures also allow traders to speculate on the price of an underlying asset, such as bitcoin (BTC) or ether (ETH) without having to directly own the cryptocurrency itself.
While perpetual futures are similar to standard futures contracts, they have one key difference: perpetual futures contracts have no expiration date.
A perpetual futures contract's two counterparties (one long, one short) pay each other on an ongoing basis. When the price of the contract is higher than the price of the underlying asset's market price, the long side pays the short side. When the price of the contract is lower than the underlying asset's market price, the short side pays the long side.
The amount depends on how far above or below the perpetual futures contract is trading versus the underlying asset's price.
These payments typically occur every 8 hours (though this can vary by exchange) and are intended to keep the perpetual futures contract's price as closely aligned with its underlying asset's market price as possible. This is a marked difference from standard futures, in which counterparties only exchange payment once, on a predetermined date in the future
For example, a trader might use a perpetual contract to speculate on the price of different types of cryptocurrency in relation to the US dollar. A perpetual futures contract would allow them to do this without buying, selling or having to take custody of the BTC itself.
The BitMEX exchange introduced this type of derivative product to the cryptocurrency market in 2016. However, the Nobel Prize winning economist Robert Shiller first theorized the underlying principles of perpetual futures contracts in the early 1990s.
How do perpetual contracts work?
Funding rate mechanism
The perpetual funding rate mechanism involves traders paying or receiving fees at regular intervals. Whether they pay or receive funds depends on if the price of the contract is trading above or below the spot market price of the asset, as well as whether they have taken a long or short position.
Since perpetual contracts have no expiration date, this funding rate keeps the price of the contract anchored to the spot price of the underlying asset over time.
If the price of the swap contract is higher than the market price of the underlying asset, the contract’s funding rate is said to be positive. In this situation, when the contract is trading at a premium (above the spot price), long position holders pay short position holders a funding rate fee.
The opposite is true if the contract price is lower than the spot market price of the underlying asset. In this situation, the contract is said to be trading at a discount and short position holders pay long position holders the funding rate fee.
This mechanism, in which traders pay fees to each other, ultimately serves to incentivize market participant behavior. These incentives encourage the price of the perpetual futures contract to converge towards the asset’s spot market price. Because these contracts create arbitrage opportunities in the market, the funding rate incentivizes traders to enter positions that will earn them funding payments, which ultimately helps to bring swap and spot prices back into alignment.
By rewarding traders who help correct price discrepancies and providing arbitrage opportunities, the funding rate promotes market efficiency and price discovery.
Check out this link for more information on how Kraken calculates its funding rates.
Delta-neutral arbitrage trading
Perpetual futures also encourages delta-neutral arbitrage traders to take opposing positions to collect funding rate fees.
Delta-neutral arbitrage traders seek to take advantage of price discrepancies in the market by simultaneously buying and selling assets in order to profit from the difference in prices. This type of trading is often done with derivatives such as options and futures contracts.
The goal of delta-neutral arbitrage traders is to make a profit without taking on any directional risk. This is done by creating a portfolio of assets that have a net delta of zero, meaning that the portfolio is created in an effort to not be exposed to any directional risk. This type of trading is often used to take advantage of short-term price discrepancies in the market.
Like traditional futures, traders can purchase leveraged perpetual contracts. Leverage allows traders to increase their trade position with a smaller amount of initial capital. For example, using 3x leverage, a perpetual swap trader could buy a $3,000 derivatives contract with a $1,000 deposit.
Trading leverage positions can dramatically increase profits, but it can also exacerbate losses. Funds deposited to open leverage positions are called “initial margin.” Exchanges also require funds to keep the position open, called “maintenance margin.” This is usually at least half the size of the initial margin, and allows traders to cover losses without the platform liquidating their positions.
Liquidation occurs when the market moves against a trader’s derivatives contract and funds fall below an exchange’s maintenance margin requirement. When this happens, the exchange automatically closes the position and takes the trader’s remaining funds.
How are perpetual futures different from traditional futures products?
Both perpetual futures and traditional fixed maturity futures are financial products that allow traders to speculate on the price movements of an underlying asset.
However, there are some key differences between standard futures contracts and perpetual futures contracts that traders should understand.
Because perpetuals do not have an expiration date and instead have an hourly auto-rollover feature, traders can keep their positions open indefinitely.
This differs from traditional futures contracts, which have a fixed expiration date. The fixed expiration date of traditional futures contracts means that traders need to settle their positions at expiration or close out their positions beforehand.
Regarding pricing, perpetual futures have a different pricing formula than traditional futures contracts. In order to keep the price of the perpetual contract more aligned with its underlying, perpetual futures use a funding rate which is based on long/short position demand.
Traditional futures contracts, on the other hand, often track the market price of the underlying asset using a benchmark index price based on aggregated trade data from several crypto exchanges.
Why trade perpetual futures?
One of the main benefits of perpetual is their flexibility. Traders can enter and exit positions at any time, without worrying about contract expirations.
However, perpetual futures also carry unique risks. Because they have no expiration date, traders must maintain their positions and keep a close eye on market conditions to avoid unexpected losses. Additionally, perpetual contracts can be subject to significant price volatility.
Here is a summary of the factors to consider when determining if perpetual contracts have a place in your trading strategy.
- High potential for large profits/ significant losses due to built-in leverage
- No expiration date, allowing for long-term trading strategies
- Markets remain open 24/7, allowing for flexibility in trading schedule
- Ability to short sell means traders can profit when markets decline
- Complexity may be overwhelming for new traders
How to trade perpetual contracts
To trade perpetual futures, you will need to open an account with a cryptocurrency exchange that offers these contracts.
Next, you need to fund your account in order to cover initial margin and maintenance margin requirements. Then you can select the contract that you wish to trade. You can then enter a position by either buying or selling the contract.
It is important to have a solid understanding of the mechanics of perpetual contracts and the risks associated with trading them before getting started. Experts often recommend having a trading plan in place and using risk management tools to minimize potential losses.
In summary, perpetual futures contracts are a flexible way to speculate on the price of an underlying asset. However, they also carry unique risks and require careful attention to market conditions. As with any financial instrument, it's important to do your research and approach derivatives trading with caution.
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