What is a futures contract?
A futures contract is an agreement to buy or sell a commodity, currency or any other financial instrument at a predetermined price at a specified time in the future.
Unlike a traditional spot market, futures transactions are not executed when they are entered into. Instead, two counterparties trade a contract over a specified period of time and, on this basis, determine future pricing policy. Additionally, the futures market does not allow users to directly purchase a digital asset because the trading process takes place in the form of a contract that represents a specific commodity and the actual trading of the asset (or cash) will occur in the future when the contract is executed.
As a simple example, consider futures on a physical commodity such as wheat or gold. In some traditional futures markets, these contracts are marked for future delivery, meaning that the commodity will be physically delivered. As a result, gold or wheat must be stored somewhere before further transportation, which creates additional transport costs. However, many futures markets now involve cash settlement, which involves the execution of a trade solely in the equivalent monetary value of the contract (without the physical exchange of goods).
In addition, the price of gold or wheat in the futures market may differ depending on the contract settlement date. The longer the time period, the higher the transportation costs, which is also reflected in potential future price uncertainty and pricing divergence between the spot and futures markets.
Why do users trade futures?
Hedging and Risk Management: This is one of the main reasons for the development of this financial instrument.
Short Exposure: Traders can bet against the price movement of an asset without owning it.
Financial Leverage: Traders can open trading positions that exceed their available balance.
What is a permanent contract?
A perpetual contract is a special type of futures, the distinguishing feature of which is that it has no expiration date. So you are given the opportunity to hold your position for as long as you deem necessary. In addition, trading of perpetual contracts is based on an underlying price index. The price index consists of the average price of an asset according to the major spot markets and their relative trading volume.
Thus, unlike conventional futures, perpetual contracts often trade at a price that is equal to or very similar to the price in the spot markets. However, the biggest difference between traditional futures and perpetual contracts is their settlement date.
What is initial margin?
Initial margin is the minimum amount you must pay to open a credit position. For example, you can buy 1000 BNB coins with an initial margin of 100 BNB (with x10 leverage). Thus, your margin will be 10% of the total order amount. Initial margin is what supports your credit position by acting as collateral.
What is maintenance margin?
Maintenance Margin is the minimum amount of collateral you must hold in your account to keep your trading positions open. If your margin balance falls below this level, you will either receive a margin call (requesting an additional deposit into your account) or your trade will be liquidated. Most cryptocurrency exchanges that provide margin trading follow the liquidation option.
In other words, initial margin is the amount you commit when you open a position, and maintenance margin refers to the minimum balance required to keep those positions open. Maintenance margin is a fairly dynamic value that changes depending on the market price of assets and the balance in your account (collateral).
What is liquidation?
If the value of your collateral falls below the maintenance margin, the funds in your futures trading account may be liquidated. On Binance, liquidation occurs differently depending on the user's risk and leverage (based on collateral and net exposure). The larger the total position, the higher the required margin.
The mechanism may differ slightly depending on the market and exchange. Binance charges a 0.5% nominal fee for Level 1 liquidations (net exposure below 500,000 USDT). If there are any additional funds in the account after liquidation, the balance is returned to the user. If the balance is less than the liquidation amount, the user is declared bankrupt.
Please note that upon liquidation you will be required to pay additional fees. To avoid this, you can either close out your positions before the liquidation price is reached, or deposit additional funds into your collateral balance, causing the liquidation to deviate further from the current market price.
What is the financing rate?
Financing consists of regular payments between buyers and sellers based on their current rate level. When the rate is above zero (positive), traders who are long (buyers of contracts) must pay those who are short (sellers of contracts). With negative rates, short positions pay long positions.
The financing rate is based on two components: the interest rate and the premium. On the Binance futures market, the interest rate is set at 0.03%, and the premium varies depending on the price difference between the futures and spot markets. Binance does not charge fees for bet transfers as they happen directly between users.
For this reason, when a perpetual contract is trading at a premium (higher than the spot markets), long positions must pay those in short positions due to the positive funding rate. It is expected that this situation will lead to a decrease in price as longs close their positions and new shorts open.
What is the marking price?
The mark price is an estimate of the true value of a contract (true price) compared to its actual trading price (the price the asset was last purchased). Calculating the mark price prevents unfair liquidation that can occur when market volatility is high.
Thus, although the index price is related to the price of the asset in the spot markets, the mark price represents the true value of the perpetual contract. In Binance, the mark price is based on the price index and funding rate, and is also an important part for calculating the “unrealized PnL”.
What is PNL?
PnL involves a profit and loss account, and it may or may not be implemented at all. When you have open positions in the perpetual contract market your PnL is not being realized, meaning that it is still changing in response to market movements. When you close your positions, the unrealized PnL becomes realized PnL (partially or fully).
Since realized PnL refers to the profit or loss that occurs as a result of closing positions, it does not directly relate to the mark price, but relates solely to the order execution price. In turn, unrealized PnL is constantly changing and is the main factor in liquidation. Thus, the marking price is used to ensure that calculations of the unrealized PnL occur accurately and correctly.
What is an insurance fund?
Simply put, an insurance fund is what prevents traders' balances from falling below zero if a trade goes wrong, and also provides a guarantee that payments will be made if the opposite happens.
To illustrate this, let's assume that Alice has $2,000 in her futures trading account, which she uses to open a long x10 leveraged position at $20 per BNB. Please note that Alice is purchasing contracts from another trader, not Binance. On the other side of the trade we have Bob with a short position of the same size.
Since the leverage is x10, Alice takes a position of 100 BNB (worth $20,000) with $2,000 collateral. However, if the price of BNB falls from $20 to $18, Alice's position will be automatically closed. This means her assets will be liquidated and the $2,000 deposit will be removed from her account.
If for any reason the system is unable to close all positions on time and the market price of the asset declines further, the insurance fund will be activated to cover all losses until the remaining positions are closed. For Alice, the situation will not change much, since she was liquidated and her balance is zero, but this procedure ensures that Bob will receive his profit anyway. In addition, without an insurance fund, Alice's balance will not only fall from $2,000 to zero, but it may also go into the red and become negative.
However, in practice, her long position will likely be closed before then because her maintenance margin will be below the required minimum. Liquidation fees go directly to the insurance fund, and any remaining funds are returned to users.
Thus, an insurance fund is a mechanism designed to use collateral received from liquidated traders to cover losses from accounts that have gone bankrupt. Under normal market conditions, the insurance fund will continually increase as users liquidate.
To summarize, the insurance fund increases when users' positions are liquidated before they reach break-even or negative value. In more extreme conditions, the system may not be able to cover all positions and the insurance fund will be used to cover possible losses. While this is rare, it can occur during periods of high volatility or low market liquidity.
What is auto-deleveraging?
Auto-leveraging refers to a counterparty liquidation method that occurs only if the insurance fund ceases to function (in certain situations). While this is unlikely to happen, should such an event occur, traders who successfully exit their positions may be required to share a portion of their profits to cover the losses of those less fortunate. Unfortunately, due to the volatility present in the cryptocurrency market and the high leverage that is offered to clients, it is impossible to completely avoid this situation.
In other words, counterparty liquidation is the final step taken when the insurance fund is unable to cover the payment of positions whose accounts have gone bankrupt due to a failed trade. Typically, positions with the highest profit (and leverage) contribute the most to the growth of the platform. Binance uses an indicator that tells users where their trades are in the queue for automatic deleveraging of funds.
In the futures market, Binance makes every effort to avoid auto-deleveraging, and therefore the platform includes several features that minimize the factors that affect this. If this does happen, the liquidation of the counterparty will be carried out without any commissions and a notification will be immediately sent to the affected traders, and users will also be given the opportunity to freely form new positions at any time of the day.
