What Are Perpetual Futures Contracts?
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What Are Perpetual Futures Contracts?

Basics

A futures contract refers to an arrangement where an individual agrees to purchase or sell a commodity, currency, or another instrument at an agreed-upon price on a specific date in the future. Unlike traditional spot markets, futures market trades are not instantly settled. Instead, two parties exchange a contract that specifies the settlement for a future date.

In a futures market, individuals do not directly purchase or sell the commodity or digital asset but trade a contract representing them. The actual trading of assets or cash only happens in the future when the contract is executed. For example, a futures contract for a physical commodity such as wheat or gold is traded in some traditional markets, which may result in the physical delivery of the commodity. However, many markets have moved towards a cash settlement approach where only the equivalent cash value is settled without any exchange of physical goods.

Moreover, the futures market price for commodities such as gold or wheat may vary based on the contract settlement date. The price difference is mainly due to carrying costs, which increase as the time gap between the contract and the settlement date grows. The higher carrying costs also increase potential future price uncertainty, leading to a wider price gap between the spot and futures market as the settlement date approaches.

Why Do Users Trade Futures Contracts? 

Futures contracts are traded for a variety of reasons, with hedging and risk management being the primary driving force behind their creation.

One reason users trade futures contracts is to hedge against potential risks in the market. By purchasing a futures contract, traders can protect themselves from possible price fluctuations and secure a predetermined price for their desired asset.

Another reason is short exposure. Even if traders do not possess a specific asset, they can still bet against its performance by entering into a futures contract. This allows investors to profit from a decline in the market.

Furthermore, futures contracts offer traders the option to leverage their positions. This means that traders can enter into agreements that exceed their account balance, enabling them to profit from larger market movements. However, leveraging also increases the level of risk associated with trading futures.

What Is a Perpetual Futures Contract? 

A perpetual futures contract is a unique type of futures contract that doesn't have an expiration date. This means that traders can hold a position for as long as they desire. Perpetual contracts are based on an underlying Index Price that reflects the average price of an asset, according to major spot markets and their trading volume.

Perpetual contracts are frequently traded at a price that is either equal to or very similar to the spot market, unlike traditional futures contracts. However, in extreme market conditions, the mark price may diverge from the spot market price. The most significant difference between traditional futures and perpetual contracts is the settlement date of the former.

What Is the Initial Margin? 

The initial margin is the minimum amount required to open a leveraged position. For instance, if you intend to buy 1,000 BNB at 10x leverage, you will need an initial margin of 100 BNB, which is equal to 10% of the total order.

The initial margin serves as collateral and supports your leveraged position. It is essential to maintain a sufficient initial margin, as a drop in the asset's value may lead to a margin call or the closure of your position.

What Is the Maintenance Margin? 

The maintenance margin is the minimum amount of collateral necessary to keep your trading positions open. If your margin balance falls below this level, you will receive a margin call to add more funds or risk being liquidated. Typically, cryptocurrency exchanges will opt for the latter.

To clarify, the initial margin is the amount you put up when opening a position, while the maintenance margin refers to the minimum balance needed to keep your positions open. This value fluctuates based on market prices and your account balance.

What Is Liquidation? 

Liquidation is a potential consequence when your collateral falls below the maintenance margin required by the exchange you are trading on. Different exchanges may have different liquidation methods, but typically the liquidation price is based on the user's risk and leverage, determined by their collateral and net exposure. The required margin increases with larger total positions.

To avoid liquidation, you can either close your positions before the liquidation price is reached, or add more funds to your collateral balance. Increasing your collateral balance will cause the liquidation price to move further away from the current market price, reducing the likelihood of liquidation.

What Is the Funding Rate? 

The funding rate is a periodic payment system between buyers and sellers, dependent on the current rate. In the case of a positive funding rate, long positions pay short positions, while the opposite happens when the funding rate is negative. This rate is a combination of two factors - the interest rate and premium, with the latter varying according to the difference in the price of futures and spot markets. In the case of a perpetual futures contract, long positions have to pay short positions when the futures contract is trading at a premium. This event may drive the price down as longs exit their positions and new shorts are initiated. The interest rate can differ from one exchange to another.

What Is the Mark Price? 

An estimate of the true value of a perpetual futures contract, when compared to its actual trading price, is called the mark price. Calculating the mark price prevents unfair liquidations that can happen when the market is highly volatile. The mark price represents the fair value of a contract and is distinct from the Index Price, which is related to the price of spot markets. The mark price calculation is based on the Index Price and the funding rate, and is also used to calculate the "unrealized PnL."

What Is PnL? 

The term PnL stands for profit and loss, which can be realized or unrealized. If you have open positions on a perpetual futures market, your PnL is unrealized and varies based on the market moves. However, when you close your positions, your unrealized PnL becomes realized PnL, which depends only on the executed price of the orders. Although realized PnL has no direct relation to the mark price, the mark price is crucial in determining the unrealized PnL, which is the primary driver for liquidations. Therefore, the mark price is essential to ensure that the calculation of unrealized PnL is fair and accurate.

What Is the Insurance Fund? 

The Insurance Fund protects losing traders from having a negative balance while ensuring profitable traders receive their earnings. Consider Alice, who opened a 10x BNB long position worth $20,000 with $2,000 collateral. If the market price drops and Alice's position is liquidated, the Insurance Fund covers her losses until the position is closed. This ensures Bob, who held the short position, receives his profit. Liquidation fees go directly to the Insurance Fund, which is continuously growing during normal market conditions. If the market is highly volatile and the system is unable to close all positions, the Insurance Fund covers potential losses.

What Is Auto-Deleveraging? 

Auto-deleveraging is a mechanism used for counterparty liquidation in rare situations when the Insurance Fund fails to function properly. Under these circumstances, profitable traders may be required to contribute a part of their profits to cover the losses of those with losing trades. Due to the inherent volatility in cryptocurrency markets, this scenario cannot always be avoided.

In such a scenario, the positions with the highest leverage and profit are targeted first, and counterparty liquidation is the last resort when the Insurance Fund cannot cover all the bankrupt positions. However, most trading systems take steps to avoid auto-deleveraging, although the specifics of such measures may differ from one exchange to another.

Conclusion

Futures contracts are a valuable tool for traders seeking to hedge against potential risks in the market or profit from short exposure. Unlike traditional futures contracts, Perpetual futures contracts do not have an expiration date, and their price is frequently traded at a similar price to the spot market. Overall, futures contracts are complex instruments, and traders need to have a solid understanding of their mechanics and the market in general before engaging in trading.

Perpetual Futures Contracts
Initial Margin
Maintenance Margin
Mark Price
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