Perpetual Futures Explained

Definition

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Perpetual futures contracts (often called perpetual swaps) are a type of derivative contract that allows traders to speculate on the future price movement of an underlying asset, such as a cryptocurrency, without an expiration date. Unlike traditional futures contracts, which require settlement on a specific future date, perpetual contracts can theoretically be held indefinitely, as long as the trader maintains sufficient margin. <ref>Glossary of Derivatives Terms</ref>

Why it matters

Perpetual futures are the most popular instrument for trading derivatives in the cryptocurrency market due to their flexibility. Their primary advantage is the lack of an expiry date, which removes the need for traders to continuously roll over positions as expiration approaches. They also commonly offer high leverage, allowing traders to control large positions with relatively small amounts of capital. <ref>Exchange Documentation on Perpetual Contracts</ref>

How it works

Perpetual contracts track the underlying spot price of the asset through a mechanism called the **funding rate**.

Tracking the Spot Price

Since perpetual contracts do not expire, they need an ongoing mechanism to keep their price tethered closely to the actual market price (the spot price) of the cryptocurrency. This is achieved through the funding rate mechanism.

Funding Rate

The funding rate is a periodic payment exchanged directly between traders holding long positions and traders holding short positions.

• **Positive Funding Rate:** If the perpetual contract price is trading higher than the spot price (indicating more bullish sentiment), long position holders pay short position holders. This incentivizes short selling and discourages excessive long buying, pushing the contract price back toward the spot price.
• **Negative Funding Rate:** If the perpetual contract price is trading lower than the spot price (indicating more bearish sentiment), short position holders pay long position holders. This incentivizes long buying and discourages excessive short selling.

The frequency of these payments varies by exchange but typically occurs every one to eight hours. <ref>Academic Paper on Crypto Derivatives Pricing</ref>

Margin and Leverage

Trading perpetual futures requires posting collateral, known as margin. Traders use leverage to amplify potential returns, but this also amplifies potential losses. If the loss on the position exceeds the margin posted, the position faces Liquidation.

Key terms

• **Long Position:** A trade betting that the price of the underlying asset will increase.
• **Short Position:** A trade betting that the price of the underlying asset will decrease.
• **Mark Price:** The reference price used by the exchange to calculate unrealized profits/losses and determine when liquidation should occur. It is usually a blend of the index price and the last traded price, designed to prevent manipulation.
• **Index Price:** The average spot price of the underlying asset across several major spot exchanges.
• **Liquidation:** The forced closure of a trader's position by the exchange when the margin level falls below the required maintenance margin, resulting in the loss of the initial margin deposited.

Practical examples

Assume a trader believes the price of Bitcoin (BTC) will rise.

1. **Entry:** The trader opens a **Long** position on a BTC perpetual contract worth $10,000, using 10x leverage. This means the trader only needs to put up $1,000 in margin collateral. 2. **Price Movement:** If the price of BTC rises by 5%, the total value of the position increases by $500 (5% of $10,000). Since the trader only put up $1,000, this represents a 50% return on their margin ($500 / $1,000). 3. **Funding Payment:** If the funding rate is positive during this period, the trader (as the long holder) will owe a small payment to any short holders. This payment is separate from the profit/loss on the price movement. 4. **Exit:** If the trader closes the position when the price has increased by 5%, their initial $1,000 margin is returned plus the $500 profit (minus any trading fees and funding payments).

Common mistakes

A frequent mistake for beginners is overleveraging. While high leverage increases potential gains, it significantly increases the risk of rapid Liquidation. Another common error is failing to account for funding rates, which can erode profits over time, especially when holding a highly leveraged position against the prevailing market sentiment. <ref>Beginner's Guide to Crypto Futures Trading</ref>

Safety and Risk Notes

Trading perpetual futures involves substantial risk due to the use of leverage. It is possible to lose more than the initial capital deposited if the exchange structure allows for negative balances, though most major exchanges use liquidation mechanisms to prevent this. Traders should only use capital they can afford to lose and should thoroughly understand margin requirements and liquidation thresholds before entering any position. Proper risk management techniques, such as setting stop-loss orders, are essential.

See also

• A Beginner's Roadmap to Futures Trading: Key Concepts and Definitions Explained
• Leverage in Trading
• Liquidation
• Arbitrage with Perpetual Contracts

References

<references> <ref>Glossary of Derivatives Terms</ref> <ref>Exchange Documentation on Perpetual Contracts</ref> <ref>Academic Paper on Crypto Derivatives Pricing</ref> <ref>Beginner's Guide to Crypto Futures Trading</ref> </references>