What are Perpetual Futures Contracts in Crypto?

Perpetual futures contracts, also known as perpetual swaps, have emerged as a notable derivative in the cryptocurrency market, enabling traders to speculate on asset prices without an expiration date. These derivatives, unlike traditional futures contracts that bind the buyer and seller to a predetermined price at a future date, offer greater flexibility. In a perpetual futures contract, traders can take long or short positions, betting on prices moving higher or lower than the current level.

The trading mechanics of perpetual contracts are similar to traditional futures, but they offer additional leverage and don't involve the immediate exchange of the underlying assets. Unlike standard futures that have a set expiration and settlement date, perpetual contracts continue indefinitely as long as traders maintain the necessary maintenance margin, which is the minimum amount of collateral required to keep positions open.

In the rapidly evolving cryptocurrency sector, derivatives like perpetual futures, options, and futures markets have gained significant traction. By mid-2022, trading volumes on centralized exchanges for crypto derivatives soared to $3.12 trillion, accounting for around 70% of the total crypto trading volume. These products allow investors to speculate on or hedge against price movements of cryptocurrencies without actually owning them, offering a blend of adaptability and potential for higher returns compared to traditional spot trading.

Perpetuals can be traded on both centralized and decentralized exchanges, often using self-custody crypto wallets. As an example, a trader might enter a long position in a Bitcoin perpetual futures contract at $30,000 with 5x leverage. This leverage magnifies the potential profit or loss, and the trader is required to maintain at least 5% of the notional value as collateral, paying a funding rate every 8 hours. This example illustrates the perpetual contract's flexibility and the absence of a binding expiration date, allowing for indefinite position holding as long as the margin requirements are met.

Futures vs. perpetual futures contracts

Futures contracts, originally rooted in agricultural commodities like wheat, provided a mechanism for producers and wholesalers to agree on a fixed price for future delivery. This arrangement offered benefits to both parties, securing a guaranteed price for producers, especially beneficial in the case of oversupply, and ensuring wholesalers a fixed rate, advantageous in times of scarcity. Despite the risks of missing out on potential higher profits or facing higher market prices, futures contracts have been a staple in managing such uncertainties.

While these contracts continue to be used in the agricultural sector, the evolution of financial markets has seen futures increasingly employed as speculative tools. Traders, often with no intent of taking possession of the underlying commodity, use these contracts to speculate on future price movements of various assets. Upon expiration, these contracts are generally settled in cash, unless physical delivery is specifically required.

Perpetual futures represent an innovative extension of traditional futures contracts. Unique in lacking an expiry date, they eliminate the aspect of physical settlement, focusing solely on price speculation. The idea, initially proposed in 1992 to facilitate derivatives markets for illiquid assets, found little traction in traditional markets that remained focused on conventional futures.

However, the rise of cryptocurrencies provided fertile ground for the concept of perpetual futures. Introduced to address the absence of deep, liquid regular futures markets in the cryptocurrency sector, they quickly gained popularity among traders. The cryptocurrency futures market, especially following the launch of Bitcoin futures in 2014 and the subsequent introduction of perpetual futures exchanges trading the BTC/USD pair by 2015, has seen substantial growth, predominantly driven by perpetuals.

It's important to note the regulatory landscape surrounding these instruments. Commodity futures trading is heavily regulated in many countries, with entities like the U.S. Commodity Futures Trading Commission (CFTC) overseeing these activities. However, the perpetual futures market, emerging mainly from the less regulated cryptocurrency sector, often operates outside these traditional regulatory frameworks. In the U.S., platforms not registered with the CFTC cannot legally offer perpetual futures to residents. Regulated cryptocurrency futures markets, such as those on the Chicago Board Options Exchange (Cboe), continue to utilize traditional dated futures contracts.

How do perpetual futures contracts work?

Contract Mechanics: Unlike traditional futures, perpetual contracts don’t have an expiration date. This means traders can hold their positions indefinitely, or until they decide to close them, based on their market speculations.
Funding Model: A critical aspect of perpetual contracts is the funding rate, which aligns the perpetual price with the spot price of the underlying asset. This rate is exchanged periodically between long and short position holders. If the perpetual price is above the spot price, the funding rate is positive, and long position holders pay short position holders. Conversely, if the perpetual price is below the spot price, the funding rate is negative, and short position holders pay those in long positions.
Long and Short Positions: Traders can go long, expecting the asset's price to increase, or short, anticipating a price drop. For example, in a bullish market, long perpetual futures contracts may outnumber short contracts. The contract size denotes the quantity of the underlying asset involved in each transaction.
Trading Example: A trader might choose a trading pair like BTC/USD, decide to go long (expecting Bitcoin's price to increase), and use leverage to enhance their trading power. For instance, with a deposit of $100 and 10x leverage, they can control a position worth $1,000. The perpetual futures contract, in this case, might be pegged to an index price representing the spot price of Bitcoin, derived from several cryptocurrency exchanges.
Price Alignment and Trading Strategies: The perpetual futures contract price is continually realigned with the BTC/USD spot price through the funding rate mechanism. This approach ensures that the contract's price does not deviate significantly from the actual market price of Bitcoin. Traders, therefore, have to strategize their positions, considering the potential for the contract price to rise or fall in alignment with the underlying asset’s spot price.

Perpetual futures contracts offer a dynamic way to trade cryptocurrencies, with the unique aspect of no expiration date and a funding rate mechanism to maintain price alignment with the spot market. This flexibility, combined with the ability to hold long or short positions, makes perpetuals a popular choice among crypto traders. However, it's crucial for traders to understand the risks involved, including the potential for liquidation if the market moves unfavorably and the implications of the funding rate on their positions.

Pros and cons of perpetual futures trading

Perpetual futures contracts have become a significant aspect of the cryptocurrency trading landscape, offering a blend of opportunities and risks.

Advantages:

No Expiration Date: Perpetual futures stand out because they lack an expiration date, allowing positions to remain open as long as margin requirements are met. This feature offers continuous exposure to the market without the need for frequent readjustments.
High Liquidity and Leverage: These contracts typically involve highly liquid assets, providing the flexibility to enter and exit positions easily. Additionally, the option to use significant leverage can amplify potential gains, making these instruments attractive for traders seeking substantial returns.
Accessibility to Retail Investors: Unlike traditional futures contracts, perpetual futures are more accessible, often open to retail investors, broadening their appeal beyond institutional traders.

Challenges and Risks:

High Risk and Volatility: The use of leverage in perpetual futures can lead to large profits but also exposes traders to the risk of substantial losses, particularly due to the inherent volatility in cryptocurrency markets.
Counterparty Risks: Trading on centralized cryptocurrency exchanges introduces risks like potential platform bankruptcy or security breaches, which could result in the loss of funds.
Complexity for New Traders: The complexities and risks associated with perpetual futures make them less suitable for inexperienced traders.
Regulatory Concerns: These contracts often operate in unregulated or less regulated environments, leading to a lack of legal protection. In jurisdictions like the United States, they are not authorized by the Commodity Futures Trading Commission (CFTC), which adds a layer of legal risk.
Additional Risks in DeFi: When traded within decentralized finance (DeFi) platforms, perpetual futures may carry added risks of hacking, further complicating their safety profile.
Market and Counterparty Risks: The absence of an expiration date increases counterparty risk, and the need for constant alignment with market values adds to the complexity of these financial instruments.

In summary, perpetual futures offer an innovative way to trade cryptocurrencies with high leverage and liquidity, accessible to a broader range of investors. However, they carry significant risks, including market volatility, counterparty dangers, regulatory uncertainties, and specific risks associated with centralized and decentralized platforms. These factors should be carefully considered by traders before participating in perpetual futures trading.

Key elements of a perpetual futures contract

Perpetual futures contracts, while based on foundational elements like long and short positions, contract size, and funding rate, encompass several additional factors essential for a comprehensive understanding. These elements are crucial in navigating the intricacies of these financial instruments:

Index Price: This represents the market price of the underlying asset in the futures product. For instance, in a Bitcoin perpetual futures contract (perp), the index price is the aggregated market price of BTC, calculated as a weighted average across multiple exchanges.
Mark Price: This is the calculated fair value of an open futures position. It is derived from the index price of the asset and the funding rate. The mark price is crucial for determining unrealized profits or losses for users and establishing the liquidation threshold.
Spot Price: Referring to the current market price of an asset, the spot price is what you can immediately sell the asset for in the market.
Future Price: This speculative price indicates the expected future value at which the futures contract could be sold. It may vary, being higher or lower than the index price, depending on market predictions and trends.
Open Positions: These are active futures contracts that are yet to be settled but maintain sufficient maintenance margin to remain valid.
Trading Positions: This term encompasses all positions a trader has taken, including both currently open positions and those previously exited.
Open Interest: A critical metric in perpetual futures, open interest denotes the total number of outstanding contracts for a given asset. It's a marker of market liquidity and can be likened to the total number of tickets sold for a concert before it begins, indicating potential attendance but not actual turnout.

Adding to the relevance of these factors, events such as Ethereum's positive funding rate following its Shanghai upgrade, as reported by Kaiko, demonstrate the dynamic nature of these markets. Open interest and funding rates can significantly shift post-major updates or upgrades in underlying assets, affecting market liquidity and price dynamics.

Understanding these elements is vital for traders engaging in perpetual futures, offering insights into market trends, potential risks, and the overall health of the trading environment. These factors collectively contribute to making informed trading decisions in the volatile yet opportunity-rich world of cryptocurrency futures.

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What are Perpetual Futures Contracts in Crypto?

Futures vs. perpetual futures contracts

How do perpetual futures contracts work?

Pros and cons of perpetual futures trading

Key elements of a perpetual futures contract

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