Perpetual Futures in Crypto: Popularity and Risks

When perpetual futures first surfaced in the cryptocurrency market in 2016, they quickly rose to prominence. Since their debut, the trading volume of these products on platforms like BitMEX, which was the first to introduce them, has grown significantly. Crypto perpetual swaps are traded on a daily basis at a volume greater than hundreds of billions of dollars compared to other traded futures instruments. Today, we'll examine what cryptocurrency futures are, how they vary from conventional derivatives, and what dangers come with using them.

Comparing Perpetual Futures and Traditional Futures

Certain financial instruments, such as stocks, indices, currencies, cryptocurrencies, etc., are derivatives whose value is dependent on the underlying asset. They let you trade these assets without requiring you to purchase or sell the "commodity" itself.

Simply expressed, derivatives let you speculate on assets without really purchasing them. For instance, it makes sense that you would need to purchase grain from someone else before you could speculate on it.

Derivatives, on the other hand, make it simpler because you can sign a contract that gives you control over the buy price and sale date without really needing to own the asset. Although they don't exist in the real world, cryptocurrencies share a similar essence.

These contracts, also known as deliverable futures contracts, enable the parties to plan their budget ahead of time, independent of market conditions.

Another type of contract that is frequently seen in the markets is futures settlement, which are used in situations where the underlying asset cannot or will not be physically delivered (such as indices for commodities or other assets). In these situations, a settlement is made at the end of the contract rather than the commodity being delivered, and depending on the outcome, money is credited or debited.

Since there is no requirement for physical delivery, traders can utilize settlement futures primarily for speculative purposes. They can leverage their position by initiating trades larger than their available balance and wager on a decline in price without actually owning the asset.

Perpetual Futures: Mechanisms and Features 

With one significant exception, perpetual futures are fundamentally comparable to conventional futures. As their name suggests, they are contracts without an expiration date.

Until one of the parties decides to close their position, they might be exchanged continuously. A financing mechanism that assists in settling debts between long and short positions allows for this flexibility.

Purchasing an asset with the expectation that its value would increase over time is known as a long position. Your eventual reward from this transaction will be higher the stronger the growth of the asset for which you have put into a contract.

To put it simply, when you take a long position, you are purchasing an asset with the intention of selling it for a higher price down the road. In essence, it's the same as standard trading.

In contrast, a short position involves selling an asset that you do not currently own in order to buy it back later for less than its current value. The way this works is that you, as a speculator, borrow the desired asset from the broker (exchange) and sell it right away, so that later, when the price drops, you can buy it back and return it to the broker, keeping the difference for yourself. In other words, we can say that there is a constant struggle between long and short holders on the market, with the leading side paying commissions to the laggards. It is because of this system that open-ended contracts are possible.

The way cryptocurrencies interact with futures is unique and involves ideas like funding rate and marking price.

Funding rate

In the case of cryptocurrencies, the contract is settled every 8 hours, occasionally even every 4 hours, as opposed to once a day as in typical open-ended futures. When the funding rate is positive, traders who purchase long contracts will make payments to participants who sell short contracts. The mechanism reverses itself when the rate is negative, paying longs to shorts.

Marking price

The marking price is an additional signal that exchanges had to implement due to the extreme volatility of cryptocurrencies. This pricing represents good value. The indicator is computed by contrasting the asset's prices across multiple spot exchanges.

For instance, the average spot price on Kraken, Coinbase, and Bitstamp exchanges will be the marking price for the market of perpetual Bitcoin futures on Binance, the cryptocurrency exchange.

For example, the marking price can be used to determine the price when liquidating or closing a position, providing traders with additional protection against market pressures.

Assuming that the price on the futures market experienced a 10% decline, but only a 5% drop on the spot market before rapidly rising again, and that the trader had an order to close the position at the marking price, or approximately the 7% loss, the mechanism would have shielded the trader from the loss.

Risks Associated with Perpetual Futures

Because cryptocurrencies are inherently highly volatile assets, there are more opportunities for traders to profit from them but also a greater chance of risk. Derivative securities such as perpetual futures carry an extra degree of risk in comparison to the underlying asset.

In most cryptocurrency markets, leverage and poor liquidity contribute to an elevated level of risk. Leverage for trading open-ended futures from 1 to 100 and even higher is provided by numerous cryptocurrency exchanges. Because of this, there are liquidation risks even in the case of small price fluctuations.

Before granting users access to futures products, major exchanges administer questionnaires to ascertain whether users have a complete understanding of the operating principles and risk awareness. Open-ended futures, however, are solely seen by many of their users as a means of acquiring huge leverage with little collateral. The fact that novice traders frequently do not value risk management just serves to exacerbate the issue.

In certain nations, laws limit the amount of leverage in open-ended futures; in the United States, citizens are prohibited from participating in them.

Conclusion

It is always worth remembering that futures trading is associated with serious risks and interested parties should not work with them thoughtlessly. It's necessary to learn to trade well on a demo account, and only then use real money. Nevertheless, every trader should make investment decisions himself or herself, having carefully weighed all pros and cons.

SimpleSwap reminds you that this article is provided for informational purposes only and does not provide investment advice. All purchases and cryptocurrency investments are your own responsibility.