What Are Perpetual Futures Contracts: Definition and Explanation
Perpetual futures contracts are a type of financial derivative. Also known as perpetual swaps or simply ‘perps’, they represent the obligation to buy or sell an asset at a specific price in the future.
Unlike regular futures, perpetual futures do not have a settlement date. As long as the trader has enough funds, the contracts can run indefinitely, hence the term ‘perpetual’.
Difference Between Futures and Perpetual Contracts
There are some major differences between futures contracts and perpetual futures contracts, which are also called perpetual swaps.
Futures contracts
Futures contracts and perpetual futures contracts are both financial derivatives. They can be based on a wide range of similar asset classes including stocks, commodities, currencies and cryptocurrencies such as Bitcoin (BTC).
There is no need to exchange the actual asset when using futures — the trade can be concluded with an exchange of cash, thus avoiding associated costs of holding and delivery of the asset involved (known as carry costs).
The further out a settlement date is on a futures contract, the higher these carry costs can become. With that, uncertainty over the price of the underlying asset also increases as it becomes more difficult to know how that asset might perform over a long period. That uncertainty also leads to a gap forming between the price of an asset and the price of futures contracts based on it.
Perpetual futures contracts
The main difference between futures and perpetual swaps is that futures must include a settlement date — the price at which the buyer and seller agree to conclude or “exercise” the trade in the future.
By contrast, with perpetual futures, there is no settlement date, only the obligation to carry out the trade. When this happens is up to the parties involved — the only thing that can force the trade to settle is force majeure such as one party failing to meet funding requirements.
The lack of settlement date negates the need to assess what the price of the underlying asset might be at X point in the future, and thus perpetual swaps often trade much closer to spot market prices.
How do Perpetual Futures Work?
Perpetual futures contracts have become popular in the cryptocurrency space as well as among traditional asset traders.
These contracts are essentially futures without an expiry date. They allow the buyer to hold open contracts indefinitely without the obligation to buy or sell at a specific point in future.
Perpetual futures essentially solve a problem which previously kept various classes of investor from trading traditional futures. These contracts offer low maintenance costs and fees, the opportunity to use leverage and a contract price which more closely tracks spot price than traditional futures typically might.
Traditional futures have an expiry date, and so there is no question of how they relate to the spot price of the underlying asset.
Perpetual contracts have no expiry date, however, and therefore use several unique mechanisms to keep their value in line with the underlying asset spot price. These are the mark price, funding rates and insurance fund — read about the features of each below.
Perpetual futures, in short, represent an attempt to combine the best of both worlds. They offer the benefits of futures versus trading the actual asset, but give traders additional flexibility not available with ‘standard’ futures contracts.
What are perpetual futures in crypto?
Crypto perpetual futures first appeared on the derivatives exchange BitMEX in 2016. Since then, they have become a mainstay of crypto derivatives and can be traded against Bitcoin, Ethereum (ETH) and an increasing number of other altcoins.
Perpetual futures contracts in crypto make use of the unique features of the instrument — funding rates, the mark price and insurance fund, among others — to ensure that investors can trade contracts on volatile cryptoassets while closely tracking the underlying spot price.
The result has been a successful ecosystem, with multiple major exchanges seeing large volumes in perpetual futures across various major tokens.
Continue reading to discover the key components of perpetual futures contracts in crypto and how they work. The TabTrader app offers a wide variety of perpetual futures pairs from major exchanges — to find them, search for the relevant pair on the ticker search screen.
Perpetual Futures Contracts Trading: Terms You Need to Know
Here are some of the most important aspects of perpetual futures trading in crypto. Each plays a role in ensuring that crypto derivatives markets run smoothly, even in times of elevated volatility.
Liquidation
Liquidation is a component of leverage trading and is not unique to perpetual futures or derivatives in general. To read about liquidation in trading, check out the TabTrader Academy article on leverage here.
A trader using leverage to gain exposure to more of an asset (e.g. through perpetual futures) needs to maintain liquidity using margin. There are two types of margin: initial (also known as collateral) and maintenance.
Margin is what allows the exchange hosting trades to know that a futures contract buyer has the money to pay their side of the deal. Should this change, and the buyer owes more than their account balance, this balance may be liquidated — its contents wholly or partially sold off — to compensate.
In perpetual futures trading, volatility in the underlying asset price might trigger a scenario in which a trader is liquidated. To avoid any unfair liquidations during periods of exceptional volatility more common in crypto, exchanges can use both the mark price of the contract or the asset spot price to calculate margin requirements.
Note that on crypto exchanges specifically, perpetual futures and other derivatives users commonly see automatic liquidations and do not receive margin calls — a warning that liquidation is approaching and that they should add funds to their margin account.
Funding rate
Funding rates are a key component of perpetual futures trading in crypto. Exchanges use them to keep the price of contracts closer to the spot price of the underlying asset.
Funding consists of user funds and splits those who are long and short the asset. If the price of the perpetual futures contract is above the spot price, those who are short get paid the funding. The reverse is also true.
This is done to effectively balance the market — and hence traders’ expectations as the price drifts closer to spot.
When shorts are paid funding, for instance, those short traders are being rewarded for taking the opposite side of the trade to overall market sentiment.
Funding rates can and do change constantly, and each exchange can set the frequency of payments. A common interval is every 8 hours.
Mark Price
The mark price is another important mechanism in perpetual futures trading. It is used to calculate exchange users’ maintenance margin requirements.
Most of the time, perpetual futures trade near the underlying asset’s spot price, and the price of the contracts is used to calculate whether or not a user should be wholly or partially liquidated.
In exceptional circumstances, however, exchanges may have to use spot price to calculate margin requirements if the perpetual futures contract has deviated significantly. This can happen, for example, when one exchange, for whatever reason, sees a flash crash on a particular market.
Mark price use allows exchanges to guard against unnecessary liquidations and preserves users’ financial solvency in the face of price movements which are not organic.
Insurance fund
The insurance fund is a perpetual futures market mechanism that ensures winning traders get the profits owed to them even if losers are liquidated by more than their entire account balance.
This situation can happen during volatile trading periods, and can see leveraged accounts lose more money than they are worth. Here, not only are losing traders liquidated and their balance goes to zero; they might still owe money after that based on the extent of their losses.
At this point, the insurance fund kicks in, paying the difference for those traders who are already liquidated.
The insurance fund is composed of community funding, the sources of which vary by exchange.
Auto-deleveraging
Auto-deleveraging (ADL) Is a way for exchanges to avoid ‘socializing’ losses incurred during abnormal trading conditions.
Once a user’s maintenance margin is used up and liquidation occurs, the exchange will look to the insurance fund (or other proprietary mechanism) to balance losing accounts.
If, however, they cannot cover everything or liquidity is thin, the exchange will start forcibly closing positions to avoid the situation becoming untenable. This is auto-deleveraging, and exchanges take pains to keep it to a minimum.
There is a complex mathematical hierarchy for deciding the order in which positions are closed, but logically, the most profitable ones are at risk.
While undesirable, ADL is considered the lesser of two evils versus taking money from profitable users to cover others’ losses.
PnL
PnL stands for profit and loss. It refers to how much up or down a position is compared to the entry price.Realized PnL is profit or loss which materializes as a position is exited. Unrealized PnL is profit or loss on a position which is not yet closed.
It is important to note that unrealized PnL nonetheless impacts account balances and is not ‘theoretical’ until a position is closed.
Traders can be liquidated if unrealized losses, for example, reach certain thresholds (taking into account all trading factors discussed above).
Exchanges offer formulae for traders to calculate PnL at a given time.
Exchanges that support perpetual futures contracts
Crypto perpetual futures contracts first appeared on BitMEX in 2016. Since then, their popularity has increased markedly, and many major trading platforms now offer them.
The TabTrader app offers the perfect way to access perpetual futures and other derivatives trading pairs across the major exchanges — all in one place, so you can keep track of your investment portfolio anywhere, any time.
Conclusion
Perpetual futures contracts, also known as perpetual swaps or simply ‘perps’, are a special type of futures contract with no set expiry date. They offer additional features to traders while reducing risk, but are complex and require a thorough understanding of derivatives to use safely.
In crypto, perpetual futures have become extremely popular, and are now available on multiple well-known exchanges. Each exchange has its own way of managing perpetual futures markets.
