Crypto Derivatives: What are Perpetual Contracts
Understanding Perpetual Contracts
Today, we are going to understand what Perpetual Contracts are, why we use them and how they work. So let’s get started!
Perpetual contracts are gaining popularity in crypto over recent years, with data showing daily trading volumes of over $180 billion. They allow traders to hold leveraged positions without the burden of an expiration date. Unlike futures, perpetual contracts trade close to the index price of the underlying asset due to perpetual funding rates.
The perpetual swap trading product was first introduced in 2016 by crypto exchange BitMEX. Perpetual swaps offer traders a chance to take on large positions in a cryptocurrency with little money down. This opportunity to win big on small movements tends to entice a lot of people to use them, but with such big rewards comes a likewise enormous amount of risk.
Before deep diving into perpetual contracts, we’ll discuss crypto derivatives first.
What are Crypto Derivatives
Simply put, a derivative is any product or contract with a value determined by an underlying asset. In traditional financial markets, derivatives derive their value from assets such as stocks, bonds, interest rates, commodities, fiat currencies and cryptocurrencies, hence the name.
Crypto derivatives work like traditional derivatives in the sense that a buyer and a seller enter into a contract to sell an underlying asset. Such assets are sold at a predetermined time and price. As such, derivatives do not have an inherent value but rely on the value of the underlying asset. For example, an Ethereum derivative relies on and obtains value from the value of Ethereum.
Derivative trades also do not hold nor own the underlying asset. The most popular types of derivatives in crypto are futures, options and perpetual contracts.
Crypto Futures
Futures involve an agreement between a buyer and a seller to sell an asset in the future. The specific date and amount are also agreed on ahead of time. Contract details may vary, but the terms are usually similar.
Crypto Options
Options are another type of derivative contract that allows a trader to buy or sell a specific commodity at a set price on a future date. Unlike futures, however, options allow the buyer the opportunity to not buy the asset if they choose.
What is a Futures Contract?
A Futures Contract is simply an agreement between two parties to sell or buy an asset at a fixed price on a predetermined ‘future’ date. Imagine that two investors enter one of these contracts with the underlying asset being Bitcoin. One promises to sell Bitcoin at an agreed price while the other promises to buy it. At the time the contract is due, both of them must fulfil their promise regardless of where the price of Bitcoin is actually at. If the future price is higher than the original agreed price, the seller loses and the buyer wins. The opposite is true if the price goes down.
What is Perpetual Contract
A perpetual contract also called a perpetual futures contract or perpetual swap, is the most prolific type of crypto derivative, especially among day traders. A Perpetual Contract is a derivative product that is similar to a traditional Futures Contract (an agreement to buy or sell a commodity at a predetermined price at a specified time in the future). Still, with one main difference: contrary to Futures, Perpetual Contracts do not have an expiry date, so you can hold a position for as long as you like. In addition, perpetual contracts mimic the margin-based spot market and trade close to the Index Price. This allows you to amplify the outcome of the deal. Still, it also means that a decrease in the price of a commodity equal to your initial margin (the percentage of the total Funds you provided as collateral) will automatically liquidate your equity and close your position.
Going Long & Short
Perpetual Contracts are synthetic trading markets that allow for exposure to arbitrary liquid assets using stablecoin (USDC) collateral. By trading Perpetuals, you can participate in market movements, reduce risk, and make a profit by going long or short with leverage on a futures contract.
You can start trading with as little as $10 at http://dydx.exchange/.
Long
By going long, a trader buys a Perpetual contract with the expectation that the underlying asset will rise in value in the future. Rather than buying and holding the underlying asset, traders buy synthetic exposure to the asset.
Short
By going short, a trader sells a Perpetual contract with the expectation that the underlying asset will decline in value in the future. Rather than selling the underlying asset, traders sell synthetic exposure to the asset.
Trading direction
There are two directions that can be taken to trade perpetual swaps:
- If a trader thinks the price of an asset is going to increase, then they are able to open a long position.
- Alternatively, if a trader thinks the price of an asset is going to decrease, they can open a short position.
How Do Perpetual Swaps Work?
Traders can long bitcoin by purchasing perpetual swaps and selling them sometime in the future for profits. For example, Alice buys 2 BTC/USD perpetual swaps by depositing $80,000 as collateral. As such, each BTC/USD perpetual swap is worth $40,000. Assuming the price of bitcoin rises steadily to $50,000 the following month, and Alice decides to close her position, she would have generated a $10,000 profit on each perpetual swap purchased. Her total profit would be roughly $20,000.
profit = number of perpetual swaps * (current price — entry price)
profit = 2 * ($50,000 — $40,000)
profit = $20,000
It is worth noting that this calculation does not take into account the effect of funding rates on profitability of Alice. The fees paid and the rebate received by Alice as part of the exchange’s attempt to peg the perpetual swap to bitcoin’s spot price would determine the exact figure that Alice generates.
Also, Alice could take advantage of the leverage opportunities available to perpetual swap traders to multiply profits. To do this, she could purchase perpetual contracts worth double the amount she initially deposited as collateral. With this strategy, the size of her position would be $160,000 (or 4 BTC/USD perpetual swaps), even though her collateral is half of the value of perpetual swaps she is trading. In such a scenario, Alice has taken advantage of a 2x leverage. Assuming she closes her position when each BTC/USD perpetual swap is selling for $50,000, her profit will be roughly $40,000.
profit = 4 * ($50,000 — $40,000)
profit = $40,000
Interestingly, some exchanges allow traders to access up to 125x leverage in order to maximize profits. However, just as leverage amplifies profits, it also amplifies losses. From our example, using a 2x leverage exposes Alice to liquidation risk if the price of the perpetual swaps falls by 50% from the initial price she bought them.
profit = 4 * ($20,000 — $40,000)
loss = $80,000
When a trader’s unrealized loss equals the collateral deposited, exchanges automatically close the trader’s position. As such, the entirety of the collateral would be lost. Therefore, the risk that comes with using margins or trading with leverage is significant and should NOT be attempted by novice traders.
Perpetual Contracts vs Futures Contracts
Consider this example. Say that you are absolutely certain that the price of Bitcoin will go up. Unfortunately, you do not know how long it will take to do so. If the price has not gone up by the time your Futures Contract expires, you are stuck with a bad trade. However, with a Perpetual Contract, you can hold your position indefinitely. This way, you can maximize your chances of success.
What Are Perpetual Funding Rates?
Perpetual funding rates are the primary mechanism providing price stability for perpetual contracts. Funding rates work by incentivizing traders to buy perpetual contracts when the price is low relative to the index and sell when the price is high relative to the index. Although it sounds relatively simple, funding rates need to be well-designed in order to maintain price stability, otherwise, the market will be more susceptible to price deviation which increases risk and may disincentivize liquidity providers.
The primary functionality of perpetual funding rates is to place a value on any deviations that occur between the perpetual contract and a target price derived from the underlying asset. A perpetual consistently trading above the target price signifies more demand for long positions, and those holding long positions will provide funding to those holding shorts. Similarly, perpetual trading below the target price shows that shorts are more in-demand, and funding will flow from shorts to longs. The magnitude of the funding rate is correlated to the size of the deviation between perpetual and target price.
The two primary price concepts for funding rates are:
Index Price: The index price is the average spot price of the underlying asset across multiple exchanges.
Mark Price: The marked price is the primary reference point for calculating the funding rate and is derived from the index price, although it may factor in a decaying basis rate that accounts for the time until the next payment.
There are typically two main components involved in funding rate calculations:
Interest Rate: The interest rate is typically constant and will depend on the assets that the perpetual derives its value.
Premium Component: The premium component is used to quantify the deviation between the perpetual price and the marked price. Most funding rates use a time-weighted average when calculating the premium component which makes it harder to manipulate the funding rate.
The total funding rate is then calculated by adding the interest rate and premium components.
The Benefits of Perpetual Contracts
The primary benefit of Perpetual Contracts is that you are allowed to hold them indefinitely. The lack of an expiration or execution date means that even when prices move against your position, you are not immediately stuck with a losing trade. Instead, as long as you have enough funds to maintain your positions, you can continue to hold and wait until prices move in your favour again.
The Risks of Perpetual Contracts
While trading perpetual swap contracts are highly risky they are appealing because they allow traders to speculate on the short-term or long-term price movements of digital assets without time constraints. The possibility of generating profits even when the prices of cryptocurrencies fall is also one of the added advantages of perpetual swaps.
Nevertheless, it’s advised traders should always perform their own due diligence and seek professional advice from a financial advisor before making any investment in cryptocurrency. When trading perpetual swap contracts, it’s possible a trader may lose their entire invested capital — especially when leverage is used.
Exchanges Offer Crypto Perpetual Contracts
One of the earliest exchanges to offer crypto perpetual contracts was BitMEX. As a result, many of the exchanges that followed suit derived their funding rate from BitMEX’s design and added their own tweaks. Perpetual contract markets and funding rates between exchanges can differ in margin amounts, funding intervals, update intervals, index and mark price calculations, interest rates, and more.
BitMEX
BitMEX currently offers BTC/USD, ETH/USD, and XRP/USD perpetual contracts that can be traded with up to 100x leverage. The funding rate is applied every 8 hours at 4:00, 12:00, and 20:00 UTC, and users only pay or receive funding if they hold a position at these times. The funding amount for each user scales linearly based on position size, represented by the equation:
Funding = Position Value * Funding Rate
As stated in the section above, the funding rate is composed of the interest rate and premium index. The interest rate is derived from the difference between the borrowing rates of the base and quoted currencies of the market pair the perpetual is based on (Ex. BTC and USD borrowing rates). The premium index is calculated with the following equation:
Premium Index (P) = (Max(0, Impact Bid Price — Mark Price) — Max(0, Mark Price — Impact Ask Price)) / Spot Price + Fair Basis used in Mark Price
This equation shows that the premium index depends on the difference between the marked price and the impact bid and ask prices, which are the prices required to clear the bid and ask side of the order book by a specified amount.
BitMEX calculates the interest rate and premium index every minute and then performs an 8-hour time-weighted average over the minute rates to calculate the funding rate. However, if the interest rate and premium index differ by less than 0.05%, the premium index will be zeroed out and the funding rate will equal the interest rate. This occurs when the perpetual price trades sufficiently close to the mark price for a given 8-hour window.
Binance
Binance offers perpetual contracts for BTC/USD, ETH/USD, and BCH/USD with leverage up to 125x for BTC and 75x for ETH and BCH. Binance’s perpetual funding rate is similar to BitMEX except it doesn’t use a funding basis when calculating the premium index. This means that the funding rate is calculated from scratch in every funding window with no dependence on the previous rate.
dYdX
dYdX went live with BTC/USDC perpetual contracts in May 2020, creating one of the first non-custodial perpetual markets. Funds are held in a smart contract instead of being held by a centralized party, and MakerDAO is utilized as a price-feed oracle. dYdX’s perpetual market design draws from BitMEX but has its own distinct differences.
Funding is calculated and applied every second through the use of smart contracts and the funding rate updates hourly. The goal of continuous funding is to keep perpetual and mark prices as close as possible, avoiding the funding basis that accumulates over time in other funding rate designs. dYdX uses a time-weighted impact price for premium index calculations and applies a constant interest rate of 0.03% per day.
Note: There are many other exchanges offering perpetual contracts on cryptocurrency pairs, including ByBit, OKEx, FTX, Kraken, Futureswap, and MCDEX, among others.
Wrap Up
In this article, we went through the basic understanding of Perpetual Contracts in crypto. Continue reading for more stories related to blockchain.
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