An Introduction to Perpetual Futures Contracts
Over the last few years, we’ve seen the emergence of more and more tools of traditional finance entering into the world of crypto. One of the most popular ones has been the introduction of futures contracts.
An Overview of Futures Contracts
A futures contract is a legal agreement between two parties in which one party commits to buy and the other party commits to sell a particular asset, commodity, or financial instrument at a predetermined price and date in the future. Unlike spot purchases, futures contracts do not involve immediate ownership of the underlying asset but allow investors to speculate on its future price movements.
Suppose an oil producer and buyer agree to a certain amount of oil to be traded in the future. Both parties agree to a set price to trade the oil on a predetermined date in the future, also known as the delivery date. At the time of delivery, irrespective of the oil spot price, the contract will be executed at a price agreed beforehand.
A future is a standardised contract. This means that it is the exchange that determines all the conditions (underlying assets, date of maturity, number of units,…) of the contracts. This standardisation process provides fungibility and liquidity. Hence, it allows those contracts to be easily traded with one another.
Who wants to trade futures contracts?
Futures contracts have two main characteristics that make them useful for some types of actors in the market:
- Ability to get a short exposure: allows traders to be positioned against an asset’s performance even if they don’t have it.
- Leverage: users can trade with positions that are larger than their account balance.
Those properties are interesting for:
- Hedgers: these are individuals or businesses that use futures contracts to protect themselves against volatile price movements of the underlying assets.
- Speculateurs: traders who bet on the future movement in the market and use derivatives to obtain a profit.
- Arbitrageurs: individuals who take positions in two or more assets to obtain a profit.
What are perpetual futures contracts?
In short, perpetual are future contracts but with no settlement date, allowing traders to hold them indefinitely. As a result, a trader can hold a position for as long as he would like.
Because perpetual have no expiry date, they should converge to the price of the underlying assets to avoid any arbitrage opportunities. To ensure that this is the case, there is a mechanism at work called: funding rate.
An overview of the funding rate
The funding rate is a regular payment that a trader either receives or pays if he wants to enter into a perpetual future position. When the funding rate is positive, long traders have to pay the short sellers. Conversely, when the funding rate is negative, long traders get paid by the short sellers.
It is recalculated frequently so that the spot and the perpetual market converge.
For instance, if a perpetual contract trades at a premium (perpetual price > spot price), the funding rate will generally be positive, and long traders will need to pay the short in the futures market. This restores the convergence of spot and futures as market inefficiencies are arbitraged away.
Key Vocabularies to Understand Perpetual Futures
To deeper our knowledge of perpetual contracts better, it is useful to understand some key concepts:
This is the price of the underlying asset calculated using a weighted average from multiple spot market exchanges. It is the reference price for perpetual contracts.
The mark price is an estimate of the contract price used to calculate the profit and loss account. It represents the fair value of the perpetual contract and prevents unfair liquidation that could happen in highly volatile markets. It is generally based on the Index Price and the funding rate.
The initial margin is the required collateral that you need when opening the contract. It is a security that is used to cover potential losses that may result if your position goes against you.
For instance, you can enter a position of 10 ETH with an initial margin of 1 ETH which acts as collateral. This represents a 10x leverage.
In addition to the initial margin, exchanges require traders to maintain at all times a certain level of equity in their account to keep the position open. This is the maintenance margin.
If your account drops below the maintenance margin, you will either be liquidated or get a margin call (where you will be required to add more funds to your account).
Leverage is the action of using borrowed funds to trade. It allows traders to control a big position in an asset with a relatively small amount of their own capital.
It is a double-edged sword as it amplifies both one’s gains and losses. Hence, a trader should be extra careful when using leverage as it could lead to substantial loss if the market goes against you.
Liquidation is the process of closing your positions to offset losses or when your account balance falls below the maintenance margin.
There are two main types of liquidation:
- Forced Liquidation: Your order is automatically closed when your account balance falls below a certain threshold (the maintenance margin). It is done to protect your position from incurring further losses.
- Voluntary Liquidation: It is done by the trader when he decides to close his position. It could be done to take profits or cut losses but it is not forced by external factors.
Risks and Opportunities
Perpetual contracts are a straightforward way to trade your favourite crypto assets and they offer many advantages and risks.
One of their main advantages is that they allow traders to go both long and short on an asset. This gives traders more flexibility as they can profit from either a price increase or decrease.
Furthermore, perpetual also allows traders to use leverage. This can magnify both gains and losses. While this can be seen as an advantage when it magnifies gains, it is also the main risk of perpetual as the losses are also magnified and can liquidate a trader.
- Perpetual contracts are future contracts but with no expiry dates.
- Funding rates exist to make sure that perpetual contracts converge to the spot price.
- Perpetual contracts allow a trader to go both long and short and benefit from leverage.
- Trading perpetual requires an in-depth understanding of key concepts such as mark price, maintenance margin, or leverage.