Perpetual swap contracts, also known as perpetual futures, are popular among traders, enabling them to take leveraged long and short positions in the global crypto markets. Read on to learn what perpetual swaps are and how they work.
What Are Perpetual Swap Contracts?
Perpetual swap contracts are financial derivatives that allow traders to speculate on the price movement of cryptocurrencies with leverage.
Perpetual swaps don’t have expiration dates like traditional futures contracts. Additionally, their price must be affixed to the underlying asset’s spot price.
Since the contracts don’t expire, exchanges utilize a funding rate mechanism to anchor the price. Under the mechanism, the long and short positions can be balanced by disincentivizing or incentivizing trades. Traders can receive a rebate or be charged a fee to balance the demand for both positions.
Futures vs. Perpetual Futures What’s the Difference?
Futures are financial derivative contracts that enable a buyer (seller) to buy (sell) an asset at a specific price at a predetermined date in the future. Perpetual futures (also known as perpetual swaps) contracts function in a similar way but have a few significant differences.
In fact, there are three key differences between futures and perpetual futures:
- Expiration date: Perpetual futures have no expiration date, meaning you don’t need to re-establish your position periodically. On the other hand, crypto futures have an expiration date, and traders must take new positions each time a contract expires.
- Price peg: The price of perpetual swaps must be pegged to the spot price of the underlying crypto asset. A price peg is unnecessary for crypto futures since the underlying asset’s price and the contract’s price converge as the expiry date approaches.
- Cost: Perpetual swap contracts can be more expensive than crypto futures when the cost of the funding rate mechanisms is included. In cases where traders hold onto their positions for a long period and the perpetual swap price remains higher than the spot price, the exchange will charge the traders a fee. Even if you earn a profit, the cumulative fees may significantly reduce your margins.
How Do Perpetuals Work?
As a trader, you can trade in the cryptocurrency markets without actually holding crypto. You can enter a contract with a counterparty (usually a cryptocurrency exchange) to exchange the price difference between the contract’s opening and closing.
Perpetual swap contracts derive value from underlying assets such as bitcoin or ether. You can choose to go long (buy) if your analysis suggests the asset’s price will rise or short (sell) if you expect the price to fall.
The funding rate mechanism ensures the price of the perpetual swap contract remains at par with the underlying asset’s market price. The mechanism is critical in anchoring the price, given that the contract has no expiration date.
Cryptocurrency exchanges charge or pay the funding rates to the long and short positions periodically, depending on the market movements. The prevailing interest rate and the difference between the spot and perpetual swap prices determine the funding rates. With this mechanism, exchanges can prevent discrepancies between the contract and the underlying asset.
The Risks of Trading Perpetual Futures Contracts
Perpetual swap contracts come with exciting opportunities but beware of certain risks you may face. Let’s look at some of risks of trading perpetuals:
- Potential for liquidation: The absence of expiration dates means you must maintain a sufficient margin in your account to cover potential losses. If the position moves against you and your margin balance falls below the required maintenance margin, the exchange can proceed to liquidate your position.
- Market volatility: Given the volatile nature of the cryptocurrency markets, sudden price movements can significantly impact your positions, leading to a loss.
- Unfavorable funding rates: When the funding rate is too high or low, traders may avoid holding positions for an extended period, given that unfavorable rates erode profits or even turn them into losses.
Perpetual swap contracts have enhanced cryptocurrency trading by providing a unique blend of features from futures and spot markets. As a trader, you enjoy the flexibility of holding a position indefinitely. However, keep in mind that there are risks that require careful management. Ensure you conduct thorough research to develop a trading strategy that works for you.
