What Are Perpetual Futures?
Perpetual futures, also known as perpetual swaps or “perpetuals,” are a type of derivative contract that allows traders to speculate on the future price of an asset without an expiration date. Unlike traditional futures contracts, which have a set expiry date, perpetual futures can be held indefinitely.
Perpetual futures are an increasingly popular financial instrument, especially in the world of cryptocurrency trading to speculate on cryptocurrencies like Bitcoin and Ethereum, but can also be applied to other assets like commodities and indices. They are popular because they allow a greater degree of leverage, and may be more liquid, than the spot cryptocurrency market.
Perpetual futures can be compared with perpetual options (XPOs), which also lack an expiry date.
Key Takeaways
- Perpetual futures are derivative contracts without an expiration date, allowing traders to speculate on asset prices indefinitely.
- Perpetual futures are particularly popular among traders in the cryptocurrency market.
- The funding rate mechanism helps keep perpetual futures prices close to the spot price of the underlying asset.
- Leverage is a key feature of perpetual futures, allowing traders to control larger positions with less capital, but it also comes with increased risk.
Understanding Perpetual Futures
Perpetual futures are a type of derivative contract that allows traders to speculate on the price movements of an underlying asset, without having to own or deliver the asset. Unlike traditional futures contracts, which have a fixed expiration date and settlement price, perpetual futures have no expiry and are constantly adjusted by a mechanism called the funding rate.
Perpetual futures are one of the most popular and liquid instruments in the cryptocurrency market, with more than $100 billion traded daily as of the end of 2022. They offer traders several advantages, such as leverage, hedging, and arbitrage opportunities. However, they also involve some risks and challenges, such as over-leveraging, liquidation, and volatility.
The funding rate mechanism helps to keep the perpetual futures price aligned with the spot price, as it incentivizes traders to take positions that would bring the two prices closer together. When the perpetual futures price is significantly higher or lower than the spot price, the funding rate can become more substantial, encouraging traders to take the opposite side of the market and reduce the price discrepancy.
Perpetual Futures and the Funding Rate
The funding rate is a mechanism that ensures that the price of the perpetual futures contract stays close to the spot price of the underlying asset. It is a periodic payment exchanged between the buyers (longs) and sellers (shorts) of the contract, based on the difference between the contract price and the spot price, similar in some ways to a swap contract.
The funding rate can be positive or negative, depending on market conditions. When the funding rate is positive, it means that the contract price is higher than the spot price, also known as contango. In this case, the longs pay the shorts the funding amount. When the funding rate is negative, it means that the contract price is lower than the spot price, known as backwardation. In this case, the shorts pay the longs the funding amount.
The funding rate is usually calculated based on a combination of the perpetual contract’s price, the spot price, and an interest rate component. The interest rate reflects the cost of borrowing or lending the underlying asset, while the premium index reflects the difference between the contract price and the spot price.
The formula may also include a cap and a floor to limit the maximum and minimum funding rate possible. It is important to note that the exact formula can vary depending on the specific exchange or platform you are using.
The funding rate is usually applied every eight hours on most exchanges, but some exchanges may have different intervals. The funding rate is not charged by the exchange, but by the traders themselves. Therefore, it does not affect the profitability of the exchange, but only of the traders.
The funding rate is an important factor to consider when trading perpetual futures, as it can affect your returns and risks. A high positive funding rate can erode your profits if you are long, while a high negative funding rate can erode your profits if you are short. Conversely, a low positive funding rate can boost your profits if you are short, while a low negative funding rate can boost your profits if you are long.
Main Features of Perpetual Futures
- No expiration date: As mentioned earlier, one of the primary features of perpetual futures is the lack of an expiration date. This allows traders to keep their positions open indefinitely, without the need to close or roll over the contract.
- Funding rate: To keep the price of perpetual futures close to the underlying asset’s spot price, a mechanism called the funding rate is used. This rate is paid by one side of the contract to the other, depending on the difference between the perpetual futures price and the spot price.
- Leverage: Perpetual futures enable traders to use leverage, allowing them to control a larger position with a smaller amount of capital. Leverage can amplify both profits and losses, so it’s crucial to manage risk appropriately.
- Margin requirements: Traders need to maintain a minimum margin balance to keep their positions open. If the balance falls below the maintenance margin requirement, the trader may face liquidation, where their position is closed automatically to prevent further loss.
Strategies for Trading Perpetual Futures
Speculation
This involves taking a long or short position in a perpetual futures contract based on your expectation of the future price direction of the underlying asset.
For example, if you think that Bitcoin will rise in value, you can buy a Bitcoin perpetual futures contract and profit from the price increase. Conversely, if you think that Bitcoin will fall in value, you can sell a Bitcoin perpetual futures contract and profit from the price decrease.
Speculation is a high-risk, potentially high-reward strategy that requires careful analysis and risk management.
Trend Following
Traders can use technical analysis to identify trends in the market and open long or short positions accordingly. This strategy involves following the market’s momentum, entering a position in the direction of the trend, and exiting when the trend reverses.
Hedging
Perpetual futures can be used to hedge an existing position in the underlying asset. For example, a trader holding Bitcoin could sell perpetual futures to protect against a potential price drop.
Arbitrage
Traders can exploit price discrepancies between the perpetual futures market and the spot market to make a profit using a strategy known as arbitrage. This involves buying the asset in one market and simultaneously selling it in the other, taking advantage of the price difference.
Perpetual futures are settled in cash, meaning that no physical delivery of the underlying asset is required.
Pros and Cons of Perpetual Futures
Pros
They have no expiration date, allowing traders to maintain positions indefinitely.
They can have greater liquidity compared to the spot market in some cases.
Leverage allows traders to control larger positions with less capital.
Cons
Leverage can amplify losses as well as profits, increasing the risk.
Margin requirements and liquidation risks require careful risk management.
Funding rates can be costly, depending on market conditions.
When Did Perpetual Futures First Appear?
The idea of perpetual futures was first introduced by Robert Shiller in a 1993 paper. The goal was to set up a perpetual claim on the cash flows of an illiquid asset, such as real estate.
Perpetual futures first appeared in the cryptocurrency market around 2016. BitMEX, a cryptocurrency derivatives trading platform, is widely credited with introducing the first perpetual swap contract for Bitcoin.
How Does the Funding Rate on a Perpetual Future Work in Practice?
The funding rate is applied to the notional value of a trader’s open position. For example, if a trader has a long position worth $10,000 and the funding rate is +0.01%, they would pay $1 to the short position holders. Similarly, if a trader has a short position worth $10,000 and the funding rate is -0.01%, they would receive $1 from the long position holders.
In many cases, the funding rate is applied and payments are exchanged every eight hours. In this example, the $1 payment would be made every eight hours (or three times a day) as long as the funding rate and the notional value of the open position remain the same.
Are Perpetual Futures Regulated?
Regulation for perpetual futures varies depending on the jurisdiction and the exchange offering the product. In some countries, such as the United States, perpetual futures fall under the purview of regulatory authorities like the Commodity Futures Trading Commission (CFTC). However, many cryptocurrency exchanges offering perpetual futures are located in other jurisdictions with more lenient regulations. As a trader, it’s essential to understand the regulatory landscape of the platform you’re using and ensure compliance with local laws.
The Bottom Line
Perpetual futures offer a unique opportunity for traders interested in speculating on the future price of assets without the constraints of an expiration date. With features like leverage and no expiry, perpetual futures can be an attractive option for those looking to capitalize on market trends or hedge existing positions.
However, it’s essential to understand the risks associated with trading perpetual futures, such as leverage and margin requirements, and to employ effective risk management strategies. For traders who are comfortable with these risks and have a good understanding of the mechanics of perpetual futures, this financial instrument can be a valuable addition to their trading arsenal.
As with any investment, it’s crucial to conduct thorough research and gain a solid understanding of the market before diving into perpetual futures trading.
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