If you’re interested in crypto futures trading, you’ve probably come across perpetual futures contracts. But what are they exactly? Join FMCPAY to dive deeper into the crypto finance world!
1. What Is Perpetual Futures Contract?
Imagine a financial tool that combines the advantages of spot trading with the leverage of futures contracts, yet removes the limitation of an expiration date.
They enable traders to engage in high leverage and efficient price discovery. And unlike traditional futures, they have no expiration date, allowing continuous and uninterrupted trading.
However, the complexity can make them difficult to manage. Risks such as market volatility and fluctuating funding rates are inherent, and their perpetual nature can be challenging for some traders.
To navigate these challenges, it’s essential to understand how it works and fits into your trading strategy. In the sections below, FMCPAY will explore the mechanism, advantages, and potential downsides of perpetual futures for experienced investors.
2. How Do Perpetual Futures Contracts Work?
Before diving into trading, make sure you fully understand how these derivative contracts function within the broader financial landscape, including the cryptocurrency market.
2.1. Funding rate mechanism
The funding rate mechanism is a key feature of perpetual futures contracts. Traders pay or receive fees periodically based on whether the contract price is above or below the spot market price of the underlying asset. The funding rate ensures that the contract price remains close to the spot price over time, despite the contract’s lack of expiration.
When the contract trades above the spot price, long position holders pay a funding rate fee to short position holders. Conversely, if the contract trades below the spot price, short position holders pay long position holders. This fee exchange incentivizes traders to enter positions that benefit them more, helping the perpetual futures price align with the spot market price and promoting overall market efficiency.
2.2. Delta-Neutral Arbitrage Trading
In perpetual contract trading, delta-neutral arbitrage trading is a prominent strategy. Traders employing this technique engage in buying and selling assets simultaneously to capitalize on price discrepancies, leveraging funding rate fees as a profit source. This method often involves derivatives such as options and futures contracts to achieve financial gains without taking on directional risk.
Delta-neutral arbitrage traders focus on constructing a portfolio with a net delta of zero, effectively insulating themselves from market direction fluctuations. This strategy capitalizes on short-term price discrepancies, allowing traders to earn profits while mitigating risk. This approach is well-suited for the perpetual futures market, where dynamic funding rates and price shifts create unique trading opportunities.
2.3. Leverage
Like traditional futures, Leverage in perpetual ones allows traders to control larger positions with a smaller initial investment. For instance, with 5x leverage, a trader can manage a $500 contract with only a $100 deposit. While leveraging can lead to higher profits, it also increases the risk of greater losses.
To open a leveraged position, traders must deposit an “initial margin,” and they need to maintain a “maintenance margin” to keep the position active. The maintenance margin is typically about half of the initial margin and ensures that traders can cover potential losses. If market movements cause the trader’s funds to drop below this level, the position may be liquidated, with the exchange closing it and seizing the remaining funds to cover the shortfall.
3. Key Points of Perpetual Futures
To summarize, perpetual futures contracts have some main features that you should keep in mind as follows:
- No Expiry Date: Perpetual futures are unique because they lack an expiry date, allowing traders to hold positions for as long as desired. This flexibility is a key advantage over traditional futures contracts.
- Funding Rate Mechanism: To keep the contract’s price close to the asset’s spot price, the funding rate adjusts periodically. It can be positive or negative, influencing traders’ decisions and the platform’s cash flow.
- High Leverage: With high leverage, traders can manage large positions with a small amount of capital, which can lead to significant gains or losses. Proper risk management is crucial.
- Mark-to-Market Settlement: Positions are settled regularly, adjusting the margin balance based on market movements. Falling below the maintenance margin may trigger a margin call.
- Margin Requirements: Two types of margin are involved: initial margin to open a position and maintenance margin to keep it open. These are essential for managing risks in volatile markets.
4. Strategies for Trading Perpetual Futures
Perpetual contracts offer opportunities for significant profits, which is one of their main benefits. However, to maximize effectiveness and safety in trading, you can consider the following strategies:
Speculation
Speculation in perpetual futures involves predicting the future price direction of an asset and taking a corresponding position. If you expect Bitcoin’s value to increase, buying a futures contract can be profitable. Conversely, if you predict a decrease, selling a contract might yield gains. This strategy is high-risk and high-reward, requiring careful market analysis and robust risk management.
Trend Following
Trend following uses technical analysis to identify market trends, allowing traders to open long or short positions in line with the market’s momentum. This strategy involves entering a position with the trend and exiting when the trend shows signs of reversal.
Hedging
Perpetual futures can hedge an existing position in the underlying asset. For instance, a trader holding Bitcoin might sell their contracts to protect against a potential price drop, offsetting the risk of their existing position.
Arbitrage
Arbitrage involves capitalizing on price differences between the perpetual futures and spot markets. This strategy requires buying the asset in one market and selling it in another simultaneously, allowing traders to profit from market inefficiencies and price discrepancies.
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5. Pros and Cons of Perpetual Futures
Before diving into trading, it’s crucial to understand the potential benefits and risks associated with perpetual futures. Below are the key pros and cons you should consider.
5.1. Pros
- Increased Liquidity: Perpetual futures markets often provide high liquidity, enabling you to enter or exit positions with ease and minimal price impact. Crypto liquidity providers help ensure these markets remain efficient.
- Flexibility: These contracts allow for continuous trading without the need for rollovers, offering greater flexibility in your trading approach.
- High Profits: Leveraging can amplify your profits, but it also increases your exposure to risk.
5.2. Cons
- High Risks: While leverage can enhance profits, it also poses the risk of significant losses if market conditions turn against you.
- Price Volatility: The underlying asset prices can be extremely volatile, making perpetual futures a risky option for those unprepared for such swings.
- Complexity: Understanding mechanisms like funding rates and margin requirements can be challenging for newcomers, requiring a steep learning curve. These contracts are generally not recommended for beginners.
6. Examples of Perpetual Futures Trading
Here are a few notable examples of perpetual futures contracts trading in the crypto market:
6.1. Bitcoin (BTC)
Bitcoin remains one of the most popular cryptocurrencies for perpetual futures contract trading. In February 2018, Bitcoin was priced at around $10,000. A trader who took a short position on a perpetual contract during this period could have seen significant profits by December 2018, as Bitcoin’s price fell to approximately $3,000-$4,000. If the trader had maintained their short position until this drop, they would have been able to close the contract with a substantial profit.
6.2. Ethereum (ETH)
Ethereum is another widely traded cryptocurrency with perpetual futures contracts. In May 2019, Ethereum’s price was around $230 per token. A trader who entered a long position on a perpetual contract at this time faced a downturn, as by December 2019, Ethereum’s price dropped to $130-$140 per token. Holding onto the long position during this period would have resulted in a loss rather than a profit.
6.3. Dogecoin (DOGE)
Dogecoin is a cryptocurrency famous due to its unexpected price. It has became available for perpetual futures trading on FameEX in 2021. The exchange launched Dogecoin-based perpetual contracts with up to 100x leverage, backed by Tether (USDT), the world’s largest stablecoin by market cap. Despite cryptocurrency volatility, Dogecoin’s inclusion on FameEX showed growing interest in crypto derivatives.
A savvy trader recognized this opportunity and entered a long position on a Dogecoin perpetual contract. By holding this position with an eye on further growth, the trader stood to gain substantial profits from Dogecoin’s unpredictable price movements.
These examples highlight that perpetual futures contracts trading can be profitable with proper market analysis and risk management strategies. However, success or not relies on a solid understanding of market trends and careful planning.
Conclusion
Perpetual futures are derivative contracts without an expiration date. They offer traders the opportunity to control larger positions through leverage, but this comes with heightened risk. Be sure to fully understand it before trading.
Stay tuned with FMCPAY for more crypto terminologies & insights!