Perpetual Futures - Definition

Perpetual futures, also known as perpetual swaps or simply "perpetuals," are a type of derivative contract. They allow traders to speculate on the future price movements of an asset without an expiration date. This feature sets them apart from traditional futures contracts, which have fixed settlement dates.

Key Features

• No Expiration Date: A major advantage of perpetual futures is that they do not have an expiration date. Traders can hold their positions indefinitely. This provides greater flexibility and removes the need to roll over contracts as they near expiration.
• Funding Rate Mechanism: Perpetual futures use a funding rate mechanism to keep the contract's price aligned with the underlying asset's spot price. Depending on market conditions, either long or short position holders will exchange funding fees regularly, usually every eight hours.
• Leverage: These contracts offer leverage, allowing traders to control larger positions with a smaller amount of capital. While leverage can increase profits, it also raises the risk of significant losses. Effective risk management is essential when using leverage.
• Margin Requirements: Traders must maintain a minimum margin balance to keep their positions open. If the margin falls below the maintenance requirement, the position may be automatically liquidated to prevent further losses.

History

The concept of perpetual futures was introduced by economist Robert Shiller in 1992 to create derivatives markets for illiquid assets. However, they gained significant traction with the rise of cryptocurrencies. BitMEX launched the first perpetual swap contract for Bitcoin in 2016, leading to widespread adoption in cryptocurrency trading.

How Perpetual Futures Work

Perpetual futures operate similarly to traditional futures but with key differences that enable continuous trading. Traders can take long positions (betting on price increases) or short positions (betting on price decreases) without worrying about contract expiration.

The funding rate adjusts periodically to balance the demand between long and short positions, ensuring price stability relative to the spot market.

Funding Rate Mechanism

The funding rate is crucial for maintaining price alignment between perpetual futures and the underlying asset. When the perpetual price is higher than the spot price (contango), longs pay shorts.

When the perpetual price is lower than the spot price (backwardation), shorts pay longs. This periodic payment encourages traders to take positions that help bring the futures price closer to the spot price.

Advantages of Perpetual Futures

• Flexibility: Traders can hold positions indefinitely without the need for contract rollover.
• High Liquidity: Perpetual futures often have substantial trading volumes, facilitating efficient order execution.
• Leverage: The ability to use leverage allows for greater exposure and potential returns on investment.
• Continuous Trading: Markets operate 24/7, enabling traders to respond to market movements at any time.

Risks Associated with Perpetual Futures

• Leverage Risk: While leverage can enhance profits, it can also magnify losses, leading to rapid capital depletion.
• Market Volatility: High price volatility can cause significant price swings, increasing the likelihood of liquidation.
• Funding Rate Costs: Depending on market conditions, funding rates can become expensive, impacting overall profitability.
• Complexity: The mechanisms involved, such as funding rates and margin requirements, can be challenging for new traders to understand.

Practical Applications

• Speculation: Traders use perpetual futures to speculate on the price movements of assets like Bitcoin and Ethereum. By taking long or short positions, they can profit from both rising and falling markets without owning the underlying asset.
• Hedging: Investors holding the underlying asset can use perpetual futures to hedge against potential adverse price movements. For example, a Bitcoin holder might take a short position in Bitcoin perpetual futures to protect against a price decline.
• Arbitrage: Arbitrageurs exploit price discrepancies between the perpetual futures market and the spot market. By simultaneously buying in one market and selling in the other, they can profit from the price difference.

Things to Remember

• No Expiration Date: Perpetual futures allow traders to hold positions indefinitely without needing to roll over contracts. This offers greater flexibility compared to traditional futures contracts.
• Funding Rate Mechanism: The funding rate keeps perpetual futures prices aligned with the underlying asset's spot price by enabling periodic payments between long and short positions. This helps maintain market balance.
• Leverage and Risk Management: While perpetual futures offer leverage to control larger positions with less capital, this increases both potential profits and losses. Effective risk management strategies are vital to mitigate these heightened risks.
• Regulatory and Complexity Considerations: Regulations for perpetual futures vary by jurisdiction, and the associated mechanisms can be complex for new traders. Understanding local regulations and the intricacies of perpetual futures is crucial for compliant and informed trading.