What are perpetual futures contracts?

Cryptocurrency traders often use perpetual futures contracts to speculate on the future price of a certain asset. Perpetual futures contracts require a much smaller commitment upfront, allow a high degree of leverage, and can lead to potentially significant profits. However, they come with some big risks as well, which is why they’re typically used by only experienced traders.

In this AAG Academy guide, we’ll explain what a perpetual futures contract is and how it works, and look at the potential benefits and risks in more detail.

What is a perpetual futures contract?

A perpetual futures contract is a type of derivatives contract. It is similar to a traditional futures contract in that it allows traders to speculate on the future price of an asset by agreeing to buy or sell it at a predetermined price. However, unlike a traditional futures contract, a perpetual futures contract does not have a fixed expiry date.

Instead, it is rolled over at the end of each trading period. This means that traders can hold their positions for as long as they wish, or close them whenever they see fit. Perpetual futures contracts are typically traded on cryptocurrency exchanges, allowing traders to speculate on the future price assets like Bitcoin and Ethereum, as well as smaller “altcoin” projects.

The trading of perpetual futures contracts is based on an underlying Index Price, which is a normalized average price of an asset. As a result, these contracts are typically traded at a price that is equal to or very similar to spot markets, except during extreme market conditions, when their price has a tendency to deviate from the spot market price quite a bit.

Perpetual futures contracts are leveraged instruments, which means that traders can open positions with a fraction of the funds required to open a traditional futures contract. This means that traders can open larger positions than they would normally be able to — and potentially earn larger profits. They are also decentralized, so almost anyone can access them.

How do perpetual futures contracts work?

To understand how perpetual futures contracts work, let’s use a fairly simple example. Let’s say BTC is currently trading at a spot rate of $25,000 per coin, but you’re confident that it will hit $35,000 within three months. Instead of having to spend $25,000 to acquire 1 BTC outright, you can purchase a contract that states you will buy 1 BTC at a price of $25,000.

Suppose after 30 days, the price of BTC has jumped to $32,000 and you decide it’s a good time to claim a profit. You then close the perpetual futures contract at a spot price of $32,000 and make a profit of $7,000. Alternatively, you could set up a fresh contract that states you’ll sell 1 BTC at a price of $38,000, which will cancel out the original contract you created.

In addition, since perpetual contracts do not have an expiration date, a price-anchoring method called a “funding rate” is used to provide regular payments between buyers and sellers. This balances short and long positions and helps ensure that the contract price remains close to the associated asset’s spot price. The funding rate is typically recalculated every eight hours.

As part of this agreement, you pay what’s called an initial margin, which is essentially a fee to open the contract. The price of this depends on the exchange you use to purchase the contract, but it tends to be a relatively small amount, such as 10% of the total order. This backs your position and acts as collateral, but it’s not the only collateral you’ll need.

There’s also a maintenance margin, which is an amount that must be held in your account in order to keep your contract open. If your margin balance drops below the minimum, you’ll either be called to add more funds, or you will be liquidated. Assuming you ensure the maintenance margin is always available, your contract will remain open until you decide to act on it.

What are the benefits of trading perpetual futures contracts?

As we can see from the example outlined above, the biggest benefit of perpetual futures contracts is that you can trade cryptocurrencies with a high degree of leverage. You don’t have to have the funds available to actually acquire a certain cryptocurrency to bet on whether its price will rise or fall — you only need enough to pay the margins.

Another big benefit is that perpetual futures contracts do not expire, so you can keep them open for as long as necessary. This means that not only can you wait for as long as it takes for a certain asset to reach your target price, but also that there’s no need to rush your trading decisions just because your contract is going to expire imminently.

What are the risks of trading perpetual futures contracts?

It might seem like perpetual futures contracts are an attractive trading option — and they are among many experienced traders. However, they also come with big risks that you should be aware of, particularly if you’re a newcomer to cryptocurrency trading. The biggest risk is that losses can be amplified when it comes to trading with leverage.

Continuing with the example above, let’s say you have a contract that states you will buy 1 BTC at a price of $25,000, and the maintenance margin is 25%, so you hold $6,250 worth of BTC in your account. Now let’s say that instead of rising, the value of BTC falls to $17,000, or by 32%, so your maintenance margin falls to a value of $4,250. You would now need to add an additional $2,000 worth of BTC to your account to keep the contract open, or you could lose it all.

Why are perpetual futures contracts popular?

The obvious benefits of perpetual futures contracts are the reasons why they have become so popular. The ability to trade with a high degree of leverage is incredibly attractive to those who are experienced and feel they can confidently predict how the price of certain assets will fluctuate over time — and it can lead to significant profits.

However, given that a level of experience and market knowledge is necessary to avoid potentially large losses, perpetual futures contracts are not recommended for those who are new to trading cryptocurrencies and other assets.

References:

• What are perpetual futures contracts
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• Perpetual futures contracts how do they work
• Perpetual futures and swaps in crypto