Crypto is a relatively new financial sector that’s taken principles of the past and applied them to the future. One often overlooked but crucial component of crypto’s financial engine are perpetual contracts. When it comes to the crypto space, what exactly are crypto perpetual contracts and how do they work?
What are Crypto Derivatives?
Since perpetual trading in crypto is a derivative product, it’s crucial to first understand the idea of crypto derivatives themselves before digging into crypto perpetual contracts.
A derivative, as implied in the name, is a financial product that derives its value from another asset. Derivatives are used in both the traditional and cryptocurrency markets to speculate on the value of a particular asset.
There are three primary types of crypto derivatives:
- Crypto options
- Crypto futures
- Crypto perpetual contracts
Crypto derivatives give traders another option to trade a cryptocurrency’s price action without having to worry about holding and securing the underlying asset. The derivative essentially represents holding a contract of the digital asset as opposed to holding the digital asset itself, as is the case with traditional spot trading.
Why are Crypto Derivatives Important?
Derivatives are crucial to a mature financial market because of the following factors:
- Liquidity provision: Crypto derivatives help bolster market liquidity that enables traders to open and close positions more smoothly without affecting the underlying asset’s price. This liquidity attracts more investors to the market as a result, lowering the risk for market participation.
- Risk mitigation: Being a highly-volatile asset class, crypto derivatives provide protection from unexpected volatility risk while also protecting a trader’s portfolio against losses.
- Ensuring price discovery: By going long or short, crypto derivatives enable markets to carry out their primary function – price discovery – in the most efficient way possible. Market participants can also be more confident that all available information has been accounted for in asset prices.
What are Futures Contracts?
One popular type of derivative is a futures contract. Futures can come in the forms of either longs or shorts. These contracts create an agreement and responsibility between a buyer and seller to buy (long) or sell (short) an asset at a predetermined settlement date and price. The time that the contract is valid can vary and expires upon conditions set when opening the contract.
How Do Crypto Futures Contracts Work?
Let’s lay out a hypothetical example to demonstrate how futures contracts work. Assume that the bitcoin price is trading at $30,000, and on one hand, a trader named Sam believes that the price will appreciate over the next week.
On the other hand, Jill, another crypto trader, believes that bitcoin will depreciate over the next week. Sam can open a futures contract to commit to paying $30,000 for one BTC in one week, and Jill can serve as the other half of the contract, promising to sell one BTC for $30,000 next week.
If the price of bitcoin increases to $40,000 over the next week, Sam makes a profit as he gets to purchase that bitcoin for a $10,000 discount, whereas Jill incurs a loss as she now has to sell Sam that bitcoin at $10,000 under market value. Conversely, if bitcoin were to fall to $20,000, Sam incurs a $10,000 loss since he has to pay $30,000, and Jill makes a profit by selling the bitcoin at $10,000 above market value.
What are Perpetual Swaps?
Now that you have a better understanding of futures contracts, let’s discuss perpetual trading in crypto. Perpetual swaps, or perpetual futures, are one of the most common ways for traders to long and short digital assets, and that’s because they come with three key differences from other forms of trading:
- There is no expiration or settlement date (unlike futures contracts)
- The price remains pegged to the underlying asset’s price (unlike futures contracts)
- There is no requirement to hold the underlying asset (unlike spot trading)
Perpetual swaps in crypto are ideal for traders who want to trade with the same benefits as futures contracts without having to worry about expiration dates and price deviations. Traders can hold their perpetual positions for as long as they like if their account holds a minimum amount, known as the margin. They also must pay holding fees for keeping positions open.
These fees are part of a “funding rate mechanism” that crypto perpetual contracts utilize to ensure that each swap is pegged tightly to the underlying asset’s price. It works by either incurring fees or rebates to incentivize traders to hold positions, which stabilizes buyer and seller demand so that the price remains flat relative to the asset being traded. If the price deviates to the upside, buyers would pay the funding rate to cover the difference, whereas sellers pay the funding rate to cover the difference if the price were to dip below the asset’s true valuation.
So how do perpetual swaps function in practice?
How Does Perpetual Crypto Trading Work?
Perpetual swaps follow this formula to determine profits/losses from perpetual swaps:
Profit = position_size * (current_price – entry_price)
Let’s use our bullish trader Sam again to put this equation into practice. Assume bitcoin is trading at $30,000 again, and Sam is betting that the price will rise against the US Dollar (USD). Sam can purchase two BTC/USD perpetual swap contracts by putting up $60,000 of collateral against it.
After two months, bitcoin rose to $50,000. Sam is happy with his profit and closes his position. Calculating his return, Sam made $40,000, not accounting for any periodic funding rate fees or rebates.
Profit = 2 * (50,000-30,000)
Profit = $40,000
However, if the price of bitcoin were to fall to $20,000, Sam’s two BTC/USD perpetual contracts would lose him $20,000.
Profit = 2 * (20,000-30,000)
Profit = -$20,000
Perpetual Crypto Contracts Summed Up
Whereas spot trading requires the trader to hold a position in the underlying asset, and futures contracts require establishing expiration and settlement dates, perpetual crypto trading avoids both of these potential disadvantages for traders and enables a flexible trading mechanism.
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