Perpetual futures contracts are a type of crypto derivative available to traders. Like traditional futures contracts, perpetual futures also allow traders to speculate on the price of an underlying asset like Bitcoin (BTC) or Ethereum (ETH) without directly owning the cryptocurrency itself.
While perpetual futures are similar to standard futures contracts, they have one key difference: perpetual futures contracts have no expiration date.
The two counterparties to a perpetual futures contract (one long, one short) make payments to each other on an ongoing basis.
When the contract price is higher than the market price of the underlying asset, the long side pays the short side.
When the contract price is lower than the market price of the underlying asset, the short side pays the long side.
The amount they trade depends on how high or low the perpetual futures contract is trading relative to the market price of the underlying asset.
These payments typically occur every 8 hours (although this can vary by exchange) with the goal of keeping the price of the perpetual futures contract as close to the market price of its underlying asset as possible.
This is how perpetual futures contracts differ from standard futures contracts, in which counterparties exchange payments only once, at a predetermined date in the future.
If you would like to learn more about futures contract trading, check out the Kraken Learning Center article What are Cryptocurrency Futures Contracts?
For example, traders might use perpetual contracts to speculate on the price of different types of cryptocurrencies relative to the U.S. dollar. Perpetual futures contracts would allow them to do this without buying, selling, or taking custody of the assets themselves.
The BitMEX exchange introduced this type of derivative product to the cryptocurrency market in 2016. However, the fundamentals of perpetual futures contracts were first theorized by Nobel Prize-winning economist Robert Shiller in the early 1990s.
How do perpetual contracts work?
Funding Rate Mechanism
The perpetual funding rate mechanism involves traders paying or receiving a fee at regular intervals. Whether they pay or receive funding depends on whether the contract price is above or below the spot market price of the asset, and whether they hold a long or short position.
Since perpetual contracts have no expiration date, this funding rate keeps the contract price pegged to the spot price of the underlying asset over time.
If the price of a swap contract is higher than the market price of the underlying asset, the funding rate for that contract is positive. In this case, long position holders pay the funding rate to short position holders when the contract is trading at a premium (higher than the spot price).
The opposite is true if the contract price is below the spot market price of the underlying asset. In this case, the contract is said to be trading at a discount and the short position holder pays the funding rate fee to the long position holder.
This mechanism of traders paying each other ultimately helps incentivize the behavior of market participants. These incentives encourage the price of perpetual futures contracts to move closer to the spot market price of that asset. Because these contracts create arbitrage opportunities in the market, the funding rate incentivizes traders to take positions and thereby earn funding payments, which ultimately helps bring the swap price and spot price back into line.
Funding rates can improve market efficiency and price discovery by rewarding traders who help correct price discrepancies and provide arbitrage opportunities.
Check out this link for more information on how Kraken calculates its funding rates.
Delta Neutral Arbitrage Trading
Perpetual futures also encourage delta-neutral arbitrage traders to hold opposite positions to collect funding rates.
Delta neutral arbitrage traders seek to exploit price differences in the market by buying and selling assets simultaneously in order to profit from the price difference. This type of trading is often conducted through derivatives such as options and futures contracts.
The goal of a Delta Neutral Arbitrage Trader is to earn profits without taking on any directional risk. This is done by creating a portfolio of assets that has a net delta of zero, meaning the portfolio is created in order to not be exposed to any directional risk. This type of trading is often used to take advantage of short-term price differences in the market.
Leverage
Like traditional futures, traders can purchase leveraged perpetual contracts. Leverage allows traders to increase their trading positions with less initial capital. For example, using 3x leverage, a perpetual swap trader can purchase $3,000 of derivative contracts with $1,000 in margin.
Trading leveraged positions can significantly increase profits, but can also exacerbate losses. The funds deposited to open a leveraged position are called "initial margin." The exchange also requires funds to maintain the position, called "maintenance margin." This is usually at least half of the initial margin and allows the trader to cover losses without the platform liquidating their position.
Liquidation occurs when the market moves against a trader's derivatives contract and the funds fall below the exchange's maintenance margin requirement. When this happens, the exchange automatically closes the position and takes the trader's remaining funds.
How are perpetual contracts different from traditional futures products?
Perpetual futures and traditional fixed-term futures are both financial products that allow traders to speculate on price movements of an underlying asset.
These assets can include traditional commodities like oil or wheat, as well as cryptocurrencies like Polkadot (DOT) or Monero (XMR).
However, there are some key differences between standard futures contracts and perpetual futures contracts that traders should be aware of.
Since perpetual contracts have no expiration date and instead have an automatic hourly rollover feature, traders can keep their positions open indefinitely.
This is different from traditional futures contracts which have a fixed expiration date.
Traditional futures contracts have a fixed expiration date, which means that traders need to close their positions at expiration or close them out early.
In terms of pricing, the pricing formula for perpetual futures is different from that for traditional futures contracts.
To keep the price of perpetual contracts more aligned with their underlying assets, perpetual futures use funding rates based on long/short position demand.
On the other hand, traditional futures contracts typically track the market price of the underlying asset using a benchmark index price based on aggregated trading data from multiple cryptocurrency exchanges.
Why trade perpetual futures?
One of the main benefits of perpetual is its flexibility. Traders can enter and exit positions at any time without having to worry about contract expiration.
However, perpetual futures also carry unique risks. Since they have no expiration date, traders must maintain their positions and closely monitor market conditions to avoid unexpected losses. In addition, perpetual contracts can be subject to huge price fluctuations.
Below is a summary of factors to consider when deciding whether perpetual contracts have a place in your trading strategy.
High potential for huge profits/significant losses due to built-in leverage
No expiration date, allowing for long-term trading strategies
The market remains open 24/7, with flexible trading arrangements
The ability to short sell means traders can profit when the market falls
Complexity can be overwhelming for new traders
How to trade perpetual contracts
To trade perpetual futures, you need to open an account on a cryptocurrency exchange that offers these contracts.
Next, you will need to deposit funds into your account to meet the initial and maintenance margin requirements. You can then select the contract you wish to trade. You can then open a position by buying or selling the contract.
Before you get started, it’s important to fully understand the mechanics of perpetual contracts and the risks associated with trading them. Experts often recommend developing a proper trading plan and using risk management tools to minimize potential losses.
In summary, perpetual futures contracts are a flexible way to speculate on the price of an underlying asset. However, they also carry unique risks and require careful attention to market conditions.
As with any financial instrument, it is important to do your research and approach derivatives trading with caution.
How are perpetual contracts different from traditional futures products?
Perpetual futures and traditional fixed-term futures are both financial products that allow traders to speculate on price movements of an underlying asset.
These assets can include traditional commodities like oil or wheat, as well as cryptocurrencies like Polkadot (DOT) or Monero (XMR).
However, there are some key differences between standard futures contracts and perpetual futures contracts that traders should be aware of.
Since perpetual contracts have no expiration date and instead have an automatic hourly rollover feature, traders can keep their positions open indefinitely.
This is different from traditional futures contracts which have a fixed expiration date.
Traditional futures contracts have a fixed expiration date, which means that traders need to close their positions at expiration or close them out early.
In terms of pricing, the pricing formula for perpetual futures is different from that for traditional futures contracts.
To keep the price of perpetual contracts more aligned with their underlying assets, perpetual futures use funding rates based on long/short position demand.
On the other hand, traditional futures contracts typically track the market price of the underlying asset using a benchmark index price based on aggregated trading data from multiple cryptocurrency exchanges.