Introduction
Perpetual contracts, also referred to as perpetual swaps, are a type of financial derivative that track the price of an underlying asset. Perpetuals are similar to futures contracts but without a fixed expiration date. This offers traders the advantage of being able to hold a position indefinitely while also taking advantage of leveraged collateral instead of having to purchase the underlying asset directly. This article will delve into the origins and basic principles of perpetual contracts.
Origin of perpetual futures
Economist Robert Shiller first introduced the concept of perpetual futures in 1992 as a means of providing derivatives markets for less liquid assets. It wasn't until 2016 that the first live perpetual futures contracts was launched by the cryptocurrency exchange BitMEX. These contracts, which are now unique to the crypto space, allow for high-leverage trading, sometimes exceeding 100x the margin. In 2018, dYdX became the first Decentralized Exchange (DEX) to offer trading in perpetual contracts.
Perpetual futures in crypto
The introduction of perpetual futures in the cryptocurrency market responded to the growing demand for more advanced trading products that would allow traders to take advantage of the volatility in the crypto market. The ability to hold a position indefinitely and the potential for high leverage made perpetual futures an attractive choice for active traders. Since their introduction, perpetual futures have gained significant popularity and are now offered for trading on most major exchanges.
One of the benefits of perpetual contracts is the ability to trade with high leverage, meaning that traders can take a large position with a limited amount of capital, thereby improving capital efficiency. This can be attractive to traders who want to maximize their potential returns, but it’s essential to remember that this also increases the level of risk involved.
How do perpetual contracts work?
In traditional futures contracts, traders agree to buy or sell an asset at a fixed price at a specified date in the future. Instead of buying the underlying asset directly, they purchase a contract that gives them the right to trade the asset at a future date, known as the expiration date. For instance, a trader can buy a futures contract that gives them the right to purchase 1 BTC for $20,000 one year from now. Traders use these contracts to hedge their positions and make predictions about the future price of assets.
Perpetual contracts are similar but lack an expiration date, allowing traders to hold their positions indefinitely.
In traditional futures contracts, the price of the contract fluctuates based on variables such as the time to expiration and the cost of carrying the asset. As the contract approaches the expiration date, the contract price aligns with the underlying asset price to reflect the current market price.
A unique mechanism called the funding rates is employed to maintain a price close to the underlying asset price, also known as the index price. Funding rates track the difference between the perpetual contract price and the index price, also known as the premium.
If the contract price is trading above the index price, the funding rate will be positive, and traders with long (or positive) positions will pay traders with short (or negative) positions. Conversely, if the contract price is trading below the index price, the funding rate will be negative, and traders with short positions will pay traders with long positions. This system incentivizes traders to take new positions on the profiting side, leading to price convergence. Funding rates keep the contract price near the underlying index price through financial incentives.
Trading in perpetual contracts is conducted through leveraged collateral instead of purchasing the underlying assets. This type of trading enables traders to deploy their capital and access larger positions efficiently, but it also increases the risk associated with trading.
A significant risk associated with trading perpetuals is the potential for liquidation, which occurs when the value of the trader's position drops below a certain threshold. This could lead to the forced closure of a trader's position at a loss, which can be substantial if the position was highly leveraged. Despite the potential for liquidation, leveraged trading in perpetual contracts can still be a profitable and strategic approach for traders who have a solid understanding of market conditions and risk management strategies.
Summary
Perpetuals are a beneficial tool for traders who want to adopt a long-term view on the market or who want to capitalize on the potential for leverage. However, they also carry a higher degree of risk and may not be suitable for all investors. As with any financial instrument, it is essential to thoroughly evaluate the associated risks and limitations before placing any trades.