One of the most popular products traded in the crypto space is perpetual futures. When trading perpetual futures, you have price risk without owning a financial instrument, providing you with a unique trading opportunity that allows you to potentially profit from the rise and fall of an asset’s price depending on your trading position allows for.
What is a perpetual forward contract?
A perpetual forward contract is a type of forward contract that does not have an expiration date. As a type of futures, we must first understand how futures contracts work in order 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, if you think that the price of a cryptocurrency like bitcoin will go up by the end of the month, you can open a long position with a monthly expiration date.
Perpetual futures do not have a settlement period. You can hold a trade as long as you want, provided 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 expiration time. You can close the trade whenever you want and secure your profit (or take your loss).
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 multiple exchanges.
How do perpetual contracts work?
How does a perpetual contract differ from a regular futures contract?
A perpetual contract lasts indefinitely. When buying or selling, you can execute your end of the deal whenever you want.
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 declines, you can hold the position until the price recovers to your desired level – provided you have enough margin to handle the loss.
Your PnL (Profit and Loss) remains unrealized until you close your trades. That is, it is still open to changes in market prices. You can choose to partially or fully hedge your position while in profit.
It is also important to understand the difference between initial and maintenance margin when using perpetual futures.
Initial margin is the minimum amount that you must have in order to open a position. It is more like collateral for your trading position. Maintenance margin is the minimum amount that you must have in your margin account to keep your trading position open.
The amount required to keep your trades open varies as the market price changes. If your positions continue to run at a loss, it may reach a point where the market will liquidate them. However, before liquidation occurs, exchanges usually initiate “margin calls,” where they inform you of low margin and encourage you to deposit more money to keep your position open.
Since you are only trading the price value of an underlying crypto asset, the price of a perpetual futures contract should be close to the actual price of the underlying asset. The trading system uses the funding rate to ensure that the price of a 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 is rising, the funding rate is usually positive, but when the price is falling, the funding rate is usually negative. When the funding rate is positive, traders holding short positions will be paid more than those holding long positions. On the other hand, when the perpetual futures contract trades at a discount to the spot index price, the funding rate will be negative. Sellers will, at this point, pay a small fee to buyers.
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 BTC costs $19,000 in the spot market, it could be $19,05,000 in the perpetual futures market. Therefore, when longs automatically encourage shorts when the price rises, the perpetual futures price moves closer to the underlying spot market price.
Even though the funding rate is usually a one-minute percentage of your trading position, it can increase and affect your profit and loss value in the long run, making it essential to understand how it works.