Guide to Perpetual Futures

Considered as one of the main types of derivatives, crypto perpetual futures have generated over $60 trillion in trading volumes since 2020, with Bitcoin's open interest alone topping $37.52 billion, highlighting their popularity as a financial instrument in the market, as they enable traders to hedge against price volatility or to speculate on price movements.

In this blog, we will shed light on how they work, their differences, and why they've become indispensable in the crypto trading toolkit.

What Are Perpetual Futures?

Perpetual futures, often termed as perpetual swaps, perpetual contracts, or "perpetuals," are a type of derivative contract that enable crypto traders to speculate on the future price of an asset without an expiration date. Unlike traditional futures contracts, which have a set settlement date, perpetual contracts roll over automatically, allowing positions to remain open indefinitely as long as the trader can meet the margin requirements.

Perpetual contracts allow traders to use leverage as a way to magnify their trading positions and hence potential returns, albeit with increased risk due to the volatility of the crypto market.

The pricing of perpetual contracts is typically aligned with the underlying asset's spot price through the funding rate, ensuring that the futures market remains closely tied to the actual market prices.

Perpetual futures and funding rate

The funding rate adjusts the contract's price to match the underlying asset's market price. It's determined by the difference between the perpetuals contract price and the spot price, and varies depending on whether the market expects the asset's price to rise or fall.

This rate ensures fairness by compensating either long or short positions depending on market dynamics. It's periodically updated, with specifications including:

• Calculation method: Different platforms may use different formulas to calculate the funding rate, which is often based on factors like the long-short interest rate differential, price volatility, and the premium or discount of the futures price relative to the spot price.

• Frequency of updates: While many platforms update funding rates every 8 hours, some might do so more or less frequently, affecting how often traders might pay or receive funding fees.

• Limits: To prevent extreme volatility in funding rates, platforms may set caps (maximum limits) or floors (minimum limits), ensuring that the funding rate remains within a reasonable range.

• Mark price: Designed to represent the estimated actual value of a perpetual swap contract.

Evolution of perpetual contracts

Crypto perpetual contracts were first introduced by BitMEX in 2016, allowing traders to hedge against the price volatility of Bitcoin. Their broader adoption coincided with significant market events, including the ICO boom and subsequent downturns, which saw traders increasingly turn to derivatives to hedge and speculate amidst heightened volatility. By the time regulated entities like CME and Bakkt entered the crypto derivatives space, offering their own versions of futures, crypto perpetual contracts had already established a strong foothold.

For example, BitMEX's average daily trading volume grew by 129x throughout 2017, and continued to grow. By 2019, BitMEX reported a record of over $8 billion in 24-hour trading volume.

Based on data from CoinGecko, the total daily trading volume of perpetual contracts across all exchanges was over $210 billion in the year 2022, which is about 4X the total spot trading volume.

The success of crypto perpetuals is also reflected in their funding rates. For example, the high frequency of green bars suggests that traders holding long positions are willing to pay a premium to maintain their bets on rising prices, which reflects a positive sentiment in the market. On the other hand, red bars suggest there are fewer instances where short position holders are compensating longs. This signals that bearish sentiments are less common during this period.

How Do Perpetual Futures Work?

Trading mechanism

• Perpetual futures allow traders to maintain positions indefinitely without an expiration date. This unique feature distinguishes them from traditional futures. Traders can freely enter and exit their positions according to market conditions. The pricing of perpetual futures closely follows the spot market price of the underlying asset, primarily due to the influence of the funding rate.

Funding rate mechanism

• The funding rate facilitates the alignment of the perpetual futures prices with the spot prices of the underlying assets. This rate is periodically adjusted and involves payments exchanged between holders of long positions (buyers) and short positions (sellers).

• When the market predominantly holds long positions, the funding rate becomes positive, prompting long holders to pay shorts, reflecting a bullish market outlook. Conversely, a negative funding rate indicates a bearish sentiment, with short holders compensating longs.

Purpose and market impact

• The funding rate promotes balance in the market. When too many traders are positioned long, the funding rate turns positive, making it expensive to hold long positions, and vice versa.

• This balance is essential for aligning the prices of perpetual futures with the spot market, thereby ensuring equitable trading conditions.

Why Trade Crypto Perpetual Futures?

Trading crypto perpetual futures offers several advantages:

• No expiration date: Perpetual futures don't have a set expiry, allowing traders to hold positions for as long as they want without worrying about rollover costs or the need to close and reopen positions at contract expiration. For traders, this means a seamless trading experience where positions can be maintained indefinitely.

• High leverage: Perpetual futures provide the opportunity to trade with high leverage sometimes up to 100x the initial margin. This means that traders can open larger positions with a relatively small amount of capital. For example, with a leverage of 100x, an initial margin of $100 can be used to open a position worth $10,000. This magnifies potential profits from even minor price movements.

• Hedging opportunities: Traders can use perpetuals to hedge other investments against market volatility, protecting against adverse price movements in their portfolio. For instance, if an investor holds a substantial amount of Bitcoin and anticipates short-term downside market volatility, they can open a short position in Bitcoin perpetuals to hedge their exposure. This strategy can help stabilize the portfolio’s value by balancing out any potential losses from the spot holdings with gains from the short positions in perpetuals.

How to Trade Crypto Perpetual Futures?

1. Select a trading pair: Start by choosing a trading pair, which consists of two different currencies, typically a cryptocurrency paired with a stablecoin or a fiat currency. For example, the BTC to USDT trading pair is represented as BTC/USDT.

2. Decide on your position: Determine whether to go long or short. If you anticipate the price of a cryptocurrency to increase, open a long position. On the other hand, if you analyze the price of a cryptocurrency will decrease, open a short position.

3. Use margin and leverage: Deposit a portion of the total value of the contract as collateral (margin) on a trading platform like Flipster to utilize leverage. Leverage multiplies your buying power, as well as potential profit and loss. For example, a $100 deposit with 10x leverage allows control over a $1,000 position.

4. Open a trade: After setting your leverage, proceed to open the trade. For going long, you might open a position at a certain price, say, BTC/USDT at $50,000, controlling a specific amount of Bitcoin relative to your leverage and margin.

5. Closing your position: If the market moves in your favor (e.g., Bitcoin's price rises for a long position), you can close your position at a higher price to realize a profit. Conversely, if the market moves against you (e.g., Bitcoin's price falls when you are in a long position), you can close the position at a loss to prevent further losses, especially if the price continues to move away from your predicted direction.

Strategies for Trading Perpetual Futures

Speculation

• What it means: Speculation involves predicting whether the price of an asset will rise or fall in the future and taking positions accordingly.

• How to do it: Before entering a trade, review the asset's historical price movements and current market conditions. Use technical indicators like moving averages to assess trends. If you believe the price will increase, you might buy (go long) a perpetual future; if you expect a price decrease, sell (go short).

• What to look for: Changes in market sentiment or significant upcoming events (like product launches or regulatory news) could affect prices.

Hedging

• What it means: Hedging with perpetuals helps mitigate potential losses in your cryptocurrency holdings.

• How to do it: If you own Bitcoin and fear a price drop, you could open a short position on a Bitcoin perpetual to offset potential losses in your spot holdings.

• What to look for: Calculate the appropriate hedge ratio to determine how much of your position should be hedged, ensuring you don't over or under-protect your assets.

Example: Hedge ratio calculation

The hedge ratio measures the amount of coverage an investment has against potential price movements.

Components of the Hedge:

• Asset to hedge: 100 BTC

• Instrument used for hedging: BTC futures contracts

• Size of each futures contract: 5 BTC

• Current price of BTC: $67,000

Since each contract covers 5 BTC, divide the total amount of BTC by the size of one contract:

• Number of contracts = 100 BTC / 5 BTC per contract = 20 contracts to fully hedge your position, assuming each contract is a perfect hedge.

• Total value of BTC to hedge: 100 BTC x $67,000 / BTC = $6,700,000

• Value covered per BTC: 5 BTC x $67,000 = $335,000

• Total value covered by BTC futures contracts: 20 contracts x $335,000 = $6,700,000

With BTC priced at $67,000 each, the total value at risk is $6,700,000 because it quantifies the total dollar value of the Bitcoins the investor is exposed to in the market. To mitigate this exposure, the investor deploys 20 contracts, each covering 5 Bitcoins valued at $67,000, totaling a hedge that matches the asset’s full market exposure.

This approach ensures that any potential financial impact due to price changes is mitigated, and can help as part of risk management, to potentially protect the investment's value against unpredictable market movements.

Arbitrage

• What it means: Arbitrage involves taking advantage of price differences between markets.

• How to do it: Find opportunities where a cryptocurrency is priced differently in two markets. Buy where it’s cheaper and simultaneously sell where it’s more expensive.

• What to look for: Quick execution is crucial as price discrepancies are available for only a short period of time. Tools and automated systems can help you capitalize on these opportunities faster.

Risks & Considerations

Trading volatile assets like cryptocurrencies come with unique risks that require further considerations to navigate the market effectively:

Volatility

The rapid price movements of cryptocurrencies can be daunting. To mitigate the impact of unexpected market moves, set risk management rules through the use of stop-loss and take-profit orders to automatically close positions at predetermined price levels. Educate yourself by reading market indicators such as RSI (Relative Strength Index) and moving averages to better predict price movements.

Liquidity

In the crypto market, an asset with high liquidity typically has a high volume of trades and a closely packed order book, where the gap between the buy (bid) and sell (ask) prices is small. This means that transactions can be executed swiftly and at predictable prices.

For example, Bitcoin is considered highly liquid because it has a large number of buyers and sellers, which allows it to be bought or sold almost instantly at stable prices.

Conversely, a crypto asset with low liquidity will have fewer participants and wider spreads between the buying and selling prices. This condition can lead to slippage, which occurs when a trade is executed at a different price than expected due to a lack of volume at the intended price level.

Trading more liquid crypto assets can increase the likelihood of avoiding slippage. Additionally, you can check the order book on a trading platform to gauge market depth, especially before placing large orders.

Leverage

Using leverage can amplify gains, but it also multiplies the potential losses. For instance, if a trader uses 10x leverage on a $100 deposit, they control a $1,000 position. If the market moves favorably by 5%, the gain is $50, increasing the initial investment by 50%. Conversely, if the market moves against the position by 5%, the loss is also $50, halving the initial investment.

Always calculate the total possible loss in a worst-case scenario to ensure it is within a range you can accept. Also, monitor the margin balance and avoid utilizing the full leverage available to keep a buffer against market volatility. This practice helps manage risk effectively and prevents sudden liquidation due to adverse price movements

Regulatory changes

The crypto market is subject to evolving regulations which can impact market sentiment and prices. For instance, when China announced a ban on Bitcoin mining in May 2021, it led to a rapid decline in Bitcoin's price by approximately 30% within weeks.

This regulatory action created market uncertainty as mining operations were disrupted and many had to shut down or relocate. This example underscores the importance of staying informed about cryptocurrency regulations. Therefore, traders should regularly keep updated on regulatory developments, which could help them understand the impact a news can have on the price of an asset.

Funding rates

In perpetual contracts, traders pay or receive funding rates, which can affect profitability depending on market conditions. If the current funding rate is positive, it indicates that the market is bullish, and vice-versa.

Traders should track historical funding rate data on their trading platform to identify trends and anticipate future costs or rewards. Understanding the timing of the funding intervals is crucial, especially when planning to hold a position over the funding timestamp. For instance, with a positive ongoing funding rate of 0.01% every 8 hours, longs have to pay shorts to maintain their positions, which can add up over time.

Disclaimer: This material is for information purposes only and does not constitute financial advice. Flipster makes no recommendations or guarantees in respect of any digital asset, product, or service. Trading digital assets and digital asset derivatives comes with significant risk of loss due to its high price volatility, and is not suitable for all investors.