Perpetual Futures Contracts

Publication Date :

06 Oct, 2023

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Table Of Contents

What Is A Perpetual Futures Contract?

A perpetual futures contract, often called a "perpetual contract" or "perpetual swap," is a derivative financial instrument without a predetermined expiry date, commonly used in cryptocurrency trading. It helps traders to surmise—the price movement of an underlying asset (usually a cryptocurrency) without worrying about contract expiration.

Traders can use it to escalate their positions, allowing them to control more prominent positions with less capital. This can increase potential profits and losses, making perpetual contracts popular for experienced traders seeking higher-risk, higher-reward strategies. The contract tracks the underlying asset's spot price closely. To achieve this, a funding mechanism keeps the contract's price in line with the market price.

What Is A Perpetual Futures Contract?

Perpetual futures contracts have no fixed expiration date, allowing for continuous trading.
These contracts closely track the spot price of an underlying asset, such as a cryptocurrency or commodity, providing exposure to the asset's price movements.
Perpetual contracts typically offer leverage, enabling traders to control more prominent positions with less capital. While this magnifies potential profits, it also increases potential losses.
A funding mechanism keeps the contract's price aligned with the spot market. Traders either pay or receive funding based on the contract's price relative to the spot price.

How Do Perpetual Futures Contracts Work?

A perpetual futures contract is a derivative financial instrument with no expiry date, used extensively in cryptocurrency trading. In essence, perpetual futures contracts offer a way for traders to speculate on cryptocurrency price movements with enhanced leverage and flexibility. Here's how they work:

Price Tracking: Perpetual contracts aim to track the real-time market price of the underlying asset closely. If the contract price deviates from the spot price, the funding rate adjusts periodically to encourage traders to bring the contract's price in line with the market.
Leverage: One of the critical features of perpetual contracts is the ability to use leverage. Traders can control more prominent positions than their initial margin by borrowing funds. For example, with 10x leverage, a trader can control a position size worth ten times their actual investment.
Funding Payments: To ensure that the perpetual contract price aligns with the spot market, funding payments are exchanged between long and short positions. If the contract price exceeds the spot price, long positions pay funding to short positions, and vice versa.
No Expiry Date: Unlike traditional futures contracts with set expiration dates, perpetual contracts have no expiry date. Traders can hold their positions as long as they like if they maintain adequate margin levels and manage risk.
Risk Management: Traders can employ risk management strategies such as stop-loss and take-profit orders to protect their capital and minimize potential losses. Liquidation mechanisms are also in place to prevent traders from losing more.
Arbitrage Opportunities: Perpetual contracts can create opportunities for arbitrage, where traders buy the contract at a lower price and simultaneously sell it at a higher price in the spot market (or vice versa), profiting from the price difference.

Examples

Let us explore it more through the following examples.

Example #1

Suppose a cryptocurrency trader named Alice wants to speculate on the price of Bitcoin. Alice decides to use a perpetual futures contract with 10x leverage. She has $1,000 in her trading account but can control a position worth $10,000 in Bitcoin with leverage.

If Bitcoin costs $40,000, Alice enters a long position with her leveraged capital. For every $1 Bitcoin goes up, she gains $10; for every $1 it goes down, she loses $10. While her potential profits are magnified, so are her potential losses. She sets a stop-loss order to limit her downside risk, ensuring she will only lose her initial $1,000 investment.

Over time, if Bitcoin's price increases, Alice can profit significantly from her leveraged position. However, if the price moves against her, she could face liquidation and lose her initial investment.

Example #2

In 2023, CryptoForce India launched its Perpetual Futures Trading platform. This new platform aims to revolutionize how traders engage with cryptocurrencies, offering them the flexibility of perpetual contracts with no set expiration dates.

The platform allows traders to speculate on various cryptocurrencies, allowing for both long and short positions. Perpetual contracts, known for their continuous trading capabilities, offer the potential for significant gains and enhanced risk management tools.

CryptoForce India's move comes amid the growing interest in cryptocurrencies in India and across the globe. With regulatory oversight and market dynamics evolving rapidly, this launch provides traders in India with more accessible options for participating in cryptocurrency markets while adhering to emerging regulatory frameworks.

Pros And Cons

Here's a brief representation of the pros and cons of perpetual futures contracts:

Pros:

Continuous Trading: Perpetual futures contracts offer continuous trading with no fixed expiration date. Traders can hold positions indefinitely, allowing for flexibility in managing investments.
Leverage: These contracts typically offer higher leverage, enabling traders to control larger positions with less capital. This can amplify potential profits.
Price Tracking: Perpetual contracts closely track the spot price of the underlying asset, ensuring that traders gain exposure to actual market movements.
Risk Management: Risk management tools like stop-loss orders are available, allowing traders to limit potential losses and protect their capital.
Hedging: Perpetual contracts can be used to hedge, helping businesses and investors manage risk by offsetting potential losses in other parts of their portfolios.

Cons:

High Risk: The leverage offered by these contracts can lead to significant losses. If prices move against traders, they can be liquidated, resulting in rapid and substantial losses.
Funding Fees: Funding rates, which help maintain the contract price alignment with the spot market, can result in extra costs for holding positions.
Complexity: Perpetual contracts can be complex, especially for novice traders who may not fully understand the intricacies of funding rates and continuous trading.
Funding Rate Risks: Traders must monitor funding rates to avoid incurring unnecessary costs, which can affect the overall profitability of their trades.
Regulatory Scrutiny: Regulatory authorities are increasingly scrutinizing exchanges offering perpetual contracts, which could lead to changes in the regulatory landscape.

Perpetual Futures Contract vs Traditional Futures Contract

Here's a short comparison between perpetual futures contracts and traditional futures contracts:

Aspect	Perpetual Futures Contracts	Traditional Futures Contracts
Expiration Date	No expiration date; continuous trading until closed by the trader.	Has a fixed expiration date, typically monthly or quarterly.
Price Tracking	Designed to closely track the spot price of the underlying asset.	Must be settled at the agreed price upon contract expiration.
Leverage	Typically offers higher leverage, allowing traders to control larger positions with less capital.	Leverage levels may be lower and standardized across different contracts.
Risk Management	Risk management tools available (e.g., stop-loss orders). Hedging and position adjustment can be done continuously.	Risk management tools like stop-loss orders can be used.
Funding Rates	Uses funding rates to balance the contract price with the spot market.	No funding rates are involved; the contract price is determined solely by supply and demand.
Market Liquidity	Contributes to liquidity in the underlying market due to continuous trading.	Also contributes to liquidity in the underlying asset market, especially around contract expiration.

Perpetual Futures Contract vs Options

Here's a tabular comparison of perpetual futures contracts and options:

Aspect	Perpetual Futures Contracts	Options
Contract Type	Derivative contracts	Derivative contracts
Expiration Value	Settlement based on contract price, funding rates, and funding payments.	Options can have intrinsic and extrinsic value. In-the-money options have intrinsic value, while out-of-the-money options have only extrinsic value.
Costs and Premiums	Typically no upfront premium required. Funding rates may result in costs.	Traders pay a premium to acquire options. Premiums vary based on market factors.
Settlement Process	Settled in cash based on contract price, funding rate, and funding payments.	Settled in cash (European options) or assets (American options) upon exercise.
Market Liquidity Contribution	Contributes to liquidity in the underlying market due to continuous trading.	Can contribute to liquidity in the underlying asset market, especially for heavily traded options.
Regulatory Oversight	Subject to varying degrees of regulation depending on the jurisdiction and exchange.	Regulated by financial authorities, with established rules and oversight.

Frequently Asked Questions (FAQs)

1. Are perpetual futures contracts regulated?

The regulatory status of perpetual futures contracts varies by jurisdiction and exchange. Some exchanges offering these contracts are regulated, while others may operate in less-regulated environments. It's essential to use reputable platforms and be aware of the regulatory framework in your region.

2. Can I use perpetual futures contracts for hedging or speculative purposes?

Yes, perpetual futures contracts can be used for both hedging and speculation. Traders can use them to hedge against price fluctuations or to speculate on price movements for profit.

3. What are the fees associated with perpetual futures contracts?

Fees can include trading fees, funding rates, and overnight financing costs. These fees vary between exchanges and may impact the overall profitability of your trades, so it's essential to understand the fee structure on your chosen platform.

4. How can I manage the risk when trading Perpetual Contracts?

Risk management strategies such as setting stop-loss orders, take-profit orders, and managing position sizes are essential. Traders should also closely monitor funding rates, which can impact trading costs.