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Introduction to Perpetual Futures

Introduction to Perpetual Futures

Table of Content

Introduction

Cryptocurrencies started trading initially in 2010, but it wasn’t until 2016, 6 years later, that BitMex offered their customers an exchange to trade perpetual contracts.

To know more about perpetual contracts, you should first know about futures or derivatives, and in this blog, we’re going to do just that.

So, let’s jump right into it!

What are perpetual futures?

When you buy shares, equity, or a token on an exchange, you’re buying something whose price is affected by supply and demand, company, or even economic fundamental events. In contrast, derivatives are contracts that derive their value from the underlying value of stock or currency. The accepted definition is, A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset or set of assets.

Derivatives contracts are an instrument used by entities to remove the need for significant upfront capital. They are also an excellent way to hedge risks. There are derivatives contracts like swaps, futures, options, and perpetual futures.

To understand what perpetual futures are, let’s first understand what futures are. Futures are those derivative contracts that allow a transaction between two entities regarding an asset (in this case, a cryptocurrency) at a predetermined future date and price. They can be either settled in cash or settled in assets.

Examples of such future contracts would be Quarterly futures contracts on Binance. The image below shows two quarterly futures expiring on 12/30 or December 30th, and the second expires on March 31st.

(Quarterly futures’ current market price. Source: Binance)

Perpetual futures, or Perps, are an extension to a futures contract with one slight modification; a perpetual future doesn’t have any expiration date, hence the term perpetual or never-ending. They are more widely recognized in the crypto space, as seen by the massive daily volume they pull relative to futures contracts or spot markets in crypto.

(Perpetual futures volume data. Source: Coinalyze)

Economist Robert Shiller created the perpetual futures to reduce the cost of rolling over futures. Rolling over contracts implies that traders exit their current position that is expiring and open a similar position on another futures contract that expires at a later point. It helps traders in avoiding the delivery of assets.

What are the pros of perpetual futures?

There are several advantages of using derivatives or perpetual futures instead of just buying or selling assets directly.

  • Derivatives markets have high liquidity compared to spot markets. The total market size of derivatives is estimated to be $1 quadrillion which completely overshadows the market cap of the stock market, which is estimated to be only $70 trillion.
(Derivatives Total Market Capitalization comparted to other markets. Source: Finematic)
  • You can trade on leverage which allows you to take positions bigger than your portfolio size while preserving capital. By definition, Leverage is the use of borrowed funds to increase one's trading position beyond what would be available from their cash balance alone.
Let’s say I have to take a $100 long position on BTC. I would have to buy $100 worth of BTC on spot markets. However, if I keep my leverage to 5x, I can take a $100 long position only by using $20 of my cash as $20 *5 = $100 while keeping $80 with me for other positions. This power of leverage allows you to preserve capital whenever needed.

It also brings us to the next use case, which is

  • Hedging and Risk management. Hedging is the main reason why derivatives were created in the first place, allowing you to short an asset or bet that the price of an asset will decrease in the future without owning the asset. It allows you the ability to be delta neutral in any position.
Shorting is created when a trader sells a security first with the intention of repurchasing it or covering it later at a lower price
  • Finally, as we stated above, perpetual swaps don’t have any expiration cost, saving you from rollover fees. It also saves you from keeping custody of actual assets on the expiration date since there isn’t any settling.

What are the risks of trading derivatives?

While derivatives have many benefits, they come with decent risks, and it is on you to be wary of them. As with any trading, it is essential to thoroughly research the market and understand the potential risks before entering into any trade.

  1. If you are trading any financial market, you are exposed to ongoing price fluctuations, which can lead to significant losses if the market moves against them. Additionally, crypto markets are known for their high levels of volatility and liquidity, which can make it difficult to predict price movements and manage risk effectively.
  2. If you are trading on margin, there are chances of you getting liquidated, i.e., you lose 100% of your money. Depending on your leverage, you can get liquidated very quickly, given how volatile crypto markets are.
  3. Lastly, perpetual futures have a funding rate cost associated with them. It is the fee you give for holding perpetual futures over a while and is deducted after every fixed period. We’ll be going over this next.

Funding Rate

As perpetual futures don’t have any expiration date, there is a fee implied for the price to converge or the spot price to be as close to perpetual futures prices as possible, and this fee is called Funding Rate. It is the fees paid out by entities who are long to shorts or vice-versa depending upon the price of perps w.r.t spot prices.

The funding rate is positive and is paid by the entities positioned long to those short if perps’ prices are above spot prices. No portion of this fee is taken by exchange and is fully transferred between the traders. Let’s say you are long and the funding rate is positive, i.e., you have to pay the fees, and the way to get out of this situation is to balance out by buying on the spot market and then shorting it on perps allowing you to collect funding instead of paying.

(Screenshot of funding rate of different pairs on Binance. Source: Binance)

You can also read about how Binance calculates its funding rate here.

Things you should know before trading perpetuals:

While all of the above covers the pros and cons of perpetual futures, there are a few keywords you should know before you trade as they help understand how perps work.

Leverage: Leverage in trading futures is a way for traders to increase their returns by using borrowed capital to enter into more significant positions than they would be able to with their capital alone. However, leverage can also magnify losses, so it's essential to use it carefully and understand the risks involved.

Liquidation: Liquidation refers to you losing your whole account due to the price moving against you, and the account value drops below the maintenance margin, which results in automatic liquidation. You can avoid such a scenario by adding more collateral to your account or closing the position before it hits the liquidation price.

Index Price: Index price is the weighted average price of an asset or crypto, in this case, according to significant spot markets and their volume traded in a specific period. For example, on Bybit, they use the 4-hour volume to find the index price.

Mark Price: The Mark Price is a theoretical value that represents the fair value of a perpetual futures contract based on its expected actual value compared to its current trading price.

Initial Margin: A user must pay a minimum value known as the initial margin to open a leveraged position. This initial margin acts as collateral to back the leveraged position. You can add the margin in stablecoins like USDT or BUSD, or USDC, or you can use Coin-margined perps or inverse-margined perps for which you have to pose the margin in that token itself. If you want to trade Coin margin on Binance for bitcoin, you would have to put bitcoin as a margin rather than USDT or BUSD, etc.

Maintenance Margin: The minimum amount of collateral a user must hold to keep trading positions open is known as the maintenance margin.

How to trade perpetual futures in cryptocurrency:

Users have an abundance of exchanges, whether they are centralized or decentralized.

Binance: Binance is one of the top centralized exchanges in crypto and does a daily volume of over $10 Billion spread across 357 coins and 1428 trading pairs.

Bybit: Another top centralized exchange with a daily volume of $375 Million spread across 270 coins and 350 pairs.

OKX: Last but not least, we have OKX, which does $704 Million in daily volume spread across 354 coins and over 643 pairs.

dydx: dydx is one of the top perpetual protocols on Ethereum and has a daily volume of $650 Million spread across 38 pairs.

Perpetual Protocol: Perpetual protocol is the first DEX that allowed the trading of perps and does a daily volume of $11 Million with only 17 pairs.

GMX: GMX is another popular DEX on Arbitrum, which has a total volume of $90 Billion with over 185,000 users.

Mango Markets: This is one of the first DEXs on Solana, which had close to $200 Million in TVL at its peak.

In the end, the choice of exchange depends on the user’s preferences and trading styles. For example, if a user wants a CEX with a wide range of token assets, they would prefer Binance or Bybit. On the other hand, a user looking to use a DEX for self-custody reasons and wants one with high liquidity would prefer dydx or GMX, depending on which chain they are on.

Suppose you’re trying to open a position on perps of Bitcoin on Binance; this is how you would do it:

  1. You should deposit your capital in your Futures wallet. Binance allows you to trade stablecoin margin perps or coin margined perps, depending on your deposit. Let’s say for this, you deposit USDT on Binance and want to trade the stablecoin margin perps.
  2. The next thing you do is make sure your settings are correct, and that means making sure your margin is Cross or Isolated depending on what you want and your leverage is set according to your desired risk.
  3. You put the price at which you want to execute the position and set your desired size.
  4. Click the Buy/Long or Sell/Short button, and voila! You have just put a limit order to either buy or sell BTC. Your order will be filled and show up on your positions tab below if there is someone on the other side to match your order.
(Source: Binance Futures page)

When it comes to trading on DEXs, the procedure has similarities; however, they differ on a point or two. So, let’s go through how you can trade perpetual futures on DEXs, and for this example, I would be taking dydx as my dex.

  1. Go to dydx and open up their trading portal. Upon connecting your wallet, you’ll be asked to sign and verify them for trading, and it is a gasless transaction.
  2. After that, you’ll be asked to deposit some collateral. You can select between a few coins, such as USDC, USDT, ETH, MKR, etc.
  3. Now you select the pair you want to trade, put in your limit price and size, and then click place order, and it will place your order for you. In this case, I’m going long on BTC with a size of 0.5 BTC at 17400, and Voila! You have now placed your order.
(Source: Dydx)

While the UI seems the same since dydx follows the CLOB or central Limit order book model, the way things work on DEXs is slightly different compared to how CEXs work. DEXs work on the AMM model primarily, and you can read about them here.

Conclusion

In conclusion, Perpetuals, also known as perps, are a type of derivative instrument allowing traders to speculate on the price of an underlying asset without the need for expiration or settlement. Trading perps in the crypto market can be a lucrative and exciting way to trade the crypto markets.

These instruments provide a way for traders to access leverage and a higher liquidity market and take advantage of bullish and bearish market movements.

However, it is crucial for traders to carefully consider the risks and potential rewards of trading perps and to thoroughly educate themselves on the mechanics of these instruments before getting involved.

Stay Tuned with #GooseAcademy

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Disclaimer: The statements, proposals, and details above are informational only, and subject to change. We are in early-stage development and may need to change dates, details, or the project as a whole based on the protocol, team, legal or regulatory needs, or due to developments of Solana/Serum. Nothing above should be construed as financial, legal, or investment advice.

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