What Are Perpetual Futures Contracts, and How Do They Work?
Reading Time: 4 minutesThey’re similar to a regular futures contract, but with a few key differences in how you manage them.
Perpetual futures are one of the most popular products traded in the crypto space. When trading perpetual futures, you have exposure to the price of a financial instrument without owning it, offering unique trading opportunities that allow you to potentially profit from the rise and fall in the price of an asset, depending on your trading position.
What Is a Perpetual Futures Contract?
A perpetual futures contract is a type of futures contract that does not have an expiration date. As a type of futures, we must first understand how futures contracts work to know what makes perpetual futures unique.
A futures contract allows two parties to speculate on the future value of a cryptocurrency at a predetermined price and date. It is a bet on the future price movement of an asset with an expiration date. What does this mean? Well, for example, you can open a long position with a monthly expiration date if you believe the price of a cryptocurrency, such as Bitcoin, will rise by the end of the month.
Perpetual futures do not have settlement periods. You can hold a trade for as long as you want, as long as you have enough margin to keep it open. For example, if you buy BTC/USD at $20,000, you will not be bound by any contract expiry time. You can close the trade and secure your profit (or take the loss) when you want.
Robert Shiller proposed perpetual futures contracts in 1992 to enable derivatives for markets that were not liquid. It was first introduced to cryptocurrency by BitMEX in 2016, and since then, it has continued to grow in popularity and is now available on many exchanges.
How Do Perpetual Contracts Work?
How is a perpetual contract different from a regular futures contract?
Indefinite Timing
A perpetual contract goes on indefinitely. When buying or selling, you can execute your end of the deal whenever you wish.
If you think the price of ETH will rise, you can initiate a long position and close the contract when the price rises to a point you are satisfied with. On the other hand, if the price decreases, you will also get to hold the position for as long as you want until the price recovers to your desired level—if you have enough margin to handle the loss.
Until you close your trades, your PnL (Profit and Loss) remains unrealized. That is, it is still open to changing market prices. You can choose to secure your position partially or entirely when in profit.
Trading Margin
Understanding the difference between the initial and maintenance margins is also important when using perpetual futures.
The initial margin is the minimum amount you must have to open a position. It is more like collateral for your trading position. The maintenance margin is the minimum amount you must have in your margin account to keep your trade position open.
The amount required to keep your trades open changes as the market price changes. If your positions continue to run at a loss, it could get to the point where the market will liquidate them. However, before liquidation occurs, exchanges usually initiate a ‘margin call,’ where they notify you about the low margin and encourage you to deposit more money to keep your positions open.
Funding Rate
Since you are only trading the price value of an underlying crypto asset, the price of a perpetual futures contract has to be close to the actual price of the underlying asset. The trading system uses a funding rate to ensure that the price of the perpetual futures contract does not move away from the spot market price of the underlying crypto asset.
When the market is bullish and the price rises, the funding rate is usually positive, but when the price is falling, the funding rate is usually negative. When the funding rate is positive, there will be a payment from those in long positions to traders holding short positions. On the other hand, when the perpetual futures contract trades at a discount below the spot index price, the funding rate will be negative. The sellers will, at this point, pay the buyers a small fee.
Since the prices of assets traded as perpetual contracts may differ slightly from their spot market prices, the funding rate is used to keep them as close as possible. For example, if the price of BTC is $19k in the spot market, it could be $19.05k in the perpetual futures market. Therefore, as the longs automatically incentivize the shorts when the price rises, the perpetual futures price gets closer to the underlying spot market price.
Even though the funding rate is usually a minute percentage of your trading position, it can add up and affect your profit and loss value in the long run, making it necessary to understand how it works.
Leverage
Perpetual contracts give you access to leverage. That is, you get to control a larger position than your trading balance can handle. As much as it helps you make a lot of money quickly, leverage can also be dangerous, as you can lose all your money or even more than your trading balance if you do not employ proper risk management.
An Efficient Trading Method in Bear Markets
One of the major advantages of the perpetual futures market over the spot market is that trading perpetual futures give you an edge during both bear and bull markets.
Spot traders typically refrain from adding to their positions during bear markets since the prices of crypto assets are falling. They, at best, try to use strategies to survive the bear market.
On the other hand, perpetual futures traders can hold a short position during a bear market and continue to make a profit during market downturns. With leverage, they can also make more within a little market movement than they would have made without it.
Futures Trading Risk Is Higher
Perpetual futures contracts, like other derivatives, offer tremendous benefits as they make it possible to trade cryptocurrencies without owning them. Moreover, because of leverage, they offer more potential profit in the short term compared to the spot market. Nevertheless, you can lose all your trading balance if you do not manage risk properly.
Perpetual contract trading is available on many trading platforms, including Bybit, Binance, and BitMEX.