In the crypto sphere, perpetual futures contracts allow traders to buy/sell the price of an asset, such as Bitcoin or Ethereum, without actually owning it.
What Are Perpetual Futures Contracts?
A perpetual futures contract is a financial derivative that permits traders to purchase or sell the price of an asset at a future date without owning the asset. Unlike traditional futures, perpetual contracts do not have a set expiration date or settlement time.
Thus, a trader can hold a position if they maintain sufficient margin in their accounts.
How Perpetual Futures Work
Perpetual futures contracts use a mechanism known as a funding rate unique to these contracts. With this system, the contract’s price is always within the underlying asset’s market price during a trade.
Funding Rate Mechanism
The funding rate is a small payment from one class of traders to another. In perpetual futures contracts, there’s an underlying security; the contract’s price is greater than the underlying security’s price.
Hence, the long traders in the position must pay a funding fee to short traders. This fuels the desire to sell, which helps reduce the contract price to align with the spot price.
Leverage
Perpetual futures allow traders to borrow money from the exchange, allowing individuals to open positions much larger than their original deposits. For example, a 10x leverage on a $1,000 deposit would control a $10,000 position.
However, using leverages can result in heavy losses even though they can magnify your profits.
Benefits of Trading Perpetual Futures Contracts
Those who trade perpetual futures contracts benefit from it in various ways.
No Expiration Date: Perpetual contracts do not have a predetermined expiration time. Instead, they remain in place as long as the required margin is in place.
High Liquidity: The popularity of perpetual futures on forex and cryptocurrency exchanges ensures high trade liquidity, allowing traders to enter and exit positions without severe price changes.
Hedging Opportunities: Traders can protect their portfolios. For example, if they are on a BTC/USD perpetual trade and expect its price to fall, they can open a short position to hedge against it.
Risks of Trading Perpetual Futures
While trading perpetual futures contracts offers several advantages, it also has risks.
High Volatility: The crypto market is famous for its swinging price fluctuations. This volatility opens up avenues for making quick gains but also presents the risk of suffering huge losses in very short periods.
Leverage Risks: When using leverage, the possible profits and losses are disproportionate and could result in liquidation due to a small, unfavorable price change.
Unregulated Markets: Forex and cryptocurrency exchanges’ perpetual futures are unregulated, providing traders minimal protection in case of a system breakdown.
Funding Rate Costs: Funding rates in certain volatile markets can become prohibitive for holding a long-term position because the cost grows exponentially over time.
Perpetual Futures Trading in Action
Let’s look at an example to understand how perpetual futures contracts work.
Imagine that Bitcoin’s trading value is $50,000. A trader wants to go long on the value, buying $1,000 at 10x leverage. This means they will control a $10,000 position.
If the price of Bitcoin increases by 5% to $52,500, the trader would then earn a $500 gain on the investment. In contrast, if the price of Bitcoin decreases by 5% and the selling price is set at $47,500, the trader would lose $500, or 50%, of their initial margin.
This example highlights how leverage amplifies losses and profits.
Perpetual Futures Contracts Compared to Traditional Futures
Perpetual and traditional futures have several differences.
Expiration Date: Traditional contracts run for a specified time in contrast to their perpetual variety, which does not run out.
Settlement: Assets in traditional futures are settled with commodities such as gold and oil, while perpetual futures are settled with cash only.
Proven Tips for Trading Perpetual Futures
The tips below will help you navigate perpetual futures trading as a trader.
Understand Leverage: Start with low leverage, as even the best traders face risk when investing in professional trading.
Set Stop Losses: Stop-loss orders are used to control potential losses. It liquidates your position when the market goes against you.
Risk Management: Trade with capital you can afford to lose and invest in multiple assets to reduce exposure.
Conclusion
Crypto traders prefer perpetual futures contracts to other contract types because they have no expiry date and provide opportunities to hedge and use leverage. Before starting with perpetual futures trading, one should know the general principles of its operation, how to manage the risk efficiently, and the right exchange to use.
