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Perpetual Futures Contract, What Is That?

PERPETUAL FUTURES CONTRACT

May 11, 2021 | 

752 Views | 

JOHN K MWANIKI | 

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Futures contracts are agreements between two parties whereby they commit to buying or selling the underlying assets on a future date at an agreed-upon price. Regardless of the asset's price, the traders have to execute the trade when the contract reaches its expiration date. The asset can either be a cryptocurrency, commodity, stock, bonds, or another financial asset.

But here comes another type of futures contract that is suddenly getting so popular in the cryptocurrency market.

What is a perpetual futures contract?

A perpetual futures contract is a unique form of futures contract that comes with no expiration date. The traders can hold the position for as long as they would like to. Unlike the traditional futures contracts whereby the two parties must execute the settlement on the day the contract expires, perpetual futures contracts are not bound by such rules. The involved traders are at liberty to execute the trade anytime they wish, depending on the market conditions.

Therefore, perpetual futures contracts allow the seller to sell the underlying asset if they think that the value is prone to fall in the future and the buyer to purchase the asset if they suspect the asset's price to rise in the future. Trading perpetual futures contracts depends on an index price calculated depending on the average asset price and its corresponding trade volume. 

Unlike regular futures, traders mostly trade perpetual future contracts at prices equal to spot market prices. But under severe market conditions, the market price is most likely to deviate from the spot price.

Perpetual future contracts initial margin and maintenance margin

Initial margin refers to the maximum amount you need to pay to open a leveraged position. For instance, if your initial margin is 10% of the total order, you can buy 1000BTC with an initial margin of 100BTC at a 10x leverage. The initial margin backs up your leveraged position; thus, it serves as collateral.

Maintenance margin refers to the minimum value of the collateral you need to maintain your trading positions in an open position. Suppose your maintenance margin drops below the required level, the cryptocurrency exchange either calls you to remind you to add more funds into your account, or you are liquidated.

Therefore the initial margin is the amount you commit when opening a position. In contrast, the maintenance margin is the lowest amount you need to keep the position open—the maintenance margin changes depending on your account balance and the market price.

What is a liquidation of margin accounts in perpetual futures contracts?

As a trader, if you fail to maintain the minimum account balance in your margin account, your account is liquidated. That means the exchange suspends the account, and the remaining amount is given back to you. Note that if you have a higher total position, then your required margin is also high. 

The mechanism of liquidation differs depending on the market and the exchange. The exchange can collect a nominal charge from you in the process of liquidation, which it deducts from your margin account. For instance, Binance charges a 0.5% nominal fee for tier 1 liquidations, which is a net exposure of below $500,000. If the account has no extra funds at the point of liquidation, the trader is declared bankrupt.

Here, you can add more money to your collateral balance which pushes the liquidation price further from the current market price, or you can close your positions before reaching the liquidation price.

Long and short positions in perpetual futures contracts

Like the regular futures contracts, a trader can hold a long or short position in perpetual futures contracts.  The buyer has a long position by committing to buy the asset at a set price in the future, and the seller holds a short position by agreeing to sell the asset at a fixed price in the future.

What is the funding rate?

The funding rate involves consistent payments between the buyers and the sellers. When the funding rate is higher than zero, buyers or traders that hold long positions have to pay the sellers. On the other hand, a negative finding rate means that the contract sellers pay the buyers. The funding rate is usually based on the exchange's interest rate and premium.

What is the mark price?

The mark price refers to an estimate of the actual value of a perpetual futures contract compared to its last trading price. Since the crypto market is heavily volatile, the mark price helps prevent unfair liquidations in the future. It also comes in when calculating the unrealized PnL to evaluate its accuracy.

Realized and unrealized PnLs in perpetual futures contracts

PnL means profit and loss, which can be realized or unrealized. Whenever you have open positions in a perpetual futures contract, your PnL is unrealized since it is still changing according to the market moves. So, when you close your position, the unrealized PnL converts to realized fully or partially.

The idea of insurance funds in perpetual futures contracts

Insurance funds are very beneficial as they help you protect your perpetual futures contract account from liquidation. It prevents the balance of a losing trader from getting below zero while also allowing winning traders to secure their profits.

The insurance fund uses the collateral liquidated trader's deposit to overcome the losses of bankrupt accounts. The interesting part is that these funds increase continuously when traders are liquidated before the closure of their trading positions. Because they maintain an open position, the insurance funds cover the trader's losses due to an open position.

Auto-deleveraging 

If the insurance funds cannot cover the liquidation forfeiture, auto deleveraging is an option. It allows winning traders to take a chunk of their profits to cover the losses of losing traders, but it is risky due to the volatility of the crypto market.

CONCLUSION

Perpetual futures contracts are very profitable trading instruments and help prevent the risks that come with futures contracts trading.

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