What are Perpetual Futures?
Introduction
Perpetual futures are a type of derivative contract that enables traders to speculate on the price of an asset—like Bitcoin, Ethereum, or other cryptocurrencies—without needing to buy or own the underlying asset itself. Unlike traditional futures contracts, perpetual futures don’t have an expiration date, meaning traders can hold their positions indefinitely, as long as they maintain the required margin.
In this article, we’ll cover how perpetual futures work, their unique features, and why they’re becoming a popular choice among crypto traders and experienced investors.
How Do Perpetual Futures Work?
Perpetual futures are designed to mirror the spot price of an asset, which is the current market price for buying or selling the asset immediately. To keep futures prices closely aligned with the spot price, perpetual futures use a funding rate mechanism—a unique feature that sets them apart from traditional futures.
The funding rate is a small periodic payment that traders on one side of the contract (long or short) pay to the traders on the other side. This rate incentivizes traders to balance demand, ensuring that perpetual futures prices don’t deviate significantly from the asset’s spot price.
Positive funding rate: When perpetual futures are priced higher than the spot price (indicating more demand for long positions), traders holding long positions pay a funding fee to those with short positions.
Negative funding rate: When perpetual futures are priced lower than the spot price, traders holding short positions pay the funding fee to those with long positions.
The funding rate fluctuates based on market conditions, helping perpetual futures stay as close to the asset’s spot price as possible.
Let’s walk through a practical example of trading Bitcoin perpetual futures. Imagine Alice believes that the price of Bitcoin will rise. She decides to open a long position in Bitcoin perpetual futures with 10x leverage. Alice starts with $1,000 in margin, giving her exposure to $10,000 worth of Bitcoin.
If Bitcoin’s price rises by 5%, Alice earns a 50% return on her initial capital, or $500.
However, if Bitcoin’s price drops by 5%, Alice loses $500—half of her original investment.
Additionally, Alice must pay a funding rate periodically to keep her position open. If the funding rate is positive, she pays this fee to short traders. If it’s negative, she receives funding from short traders, which helps offset some costs.
Key Features of Perpetual Futures
1. No Expiration Date
A defining characteristic of perpetual futures is their exemption from an expiration date. In traditional futures, contracts expire on a set date, meaning traders must either settle or roll over their positions when the contract expires. With perpetual futures, there’s no deadline, so traders can hold their positions for as long as they want—provided they maintain enough margin in their accounts to hold the open positions.
This feature offers flexibility, allowing traders to stay in positions for extended periods without worrying about expiration-related costs or rollovers.
2. Leverage Opportunities
Perpetual futures often allow for higher leverage, which means traders can control larger positions with a smaller amount of capital. For example, with 10x leverage, a trader can hold a $10,000 position with just $1,000 in capital. This ability to amplify exposure can lead to larger potential gains—but also comes with the risk of amplified losses.
Using leverage requires careful risk management. If the market moves against the trader, the exchange may liquidate the position to protect against further loss.
3. 24/7 Market Access
Perpetual futures are popular in cryptocurrency markets, which operate 24/7. This means traders can open or close positions at any time, taking advantage of price movements around the clock. For example, a trader may open a perpetual futures position during the weekend if there is significant price action in the cryptocurrency market, gaining flexibility that traditional markets don’t offer.
Comparing Perpetual Futures to Traditional Futures
Feature | Perpetual Futures | Traditional Futures |
|---|---|---|
Expiration Date | No expiration date | Set expiration date (daily, monthly, or quarterly) |
Funding Rate | Yes, keeps price aligned with spot price | No funding rate |
Leverage | Often high, up to 100x | Typically lower, varies by exchange |
Market Access | 24/7 in crypto markets | Limited to traditional market hours |
Why Trade Perpetual Futures?
1. Flexibility
Since perpetual futures don’t expire, traders have more control over when they enter and exit positions. This flexibility is particularly valuable for those who want to capitalize on long-term market trends without the hassle of contract rollovers, as is necessary with traditional futures.
2. Leverage to Amplify Returns
The ability to use leverage allows traders to control larger positions with less capital, potentially increasing returns on successful trades. However, it’s essential to remember that leverage also amplifies potential losses. Traders must maintain their margin to avoid liquidation, especially during market volatility.
3. Hedging Against Price Movements
Perpetual futures also serve as an effective hedging tool. For example, if a trader holds a significant amount of Bitcoin and expects a short-term price decline, they may open a short position in Bitcoin perpetual futures to offset potential losses. This short hedge helps protect against unfavorable market price movements while allowing the trader to keep their underlying assets.
Risks Involved in Perpetual Futures Trading
While perpetual futures offer unique benefits, they also come with inherent risks, especially when leverage is involved. Here are a few key risks to consider:
1. Liquidation Risk
With leveraged positions, there is always a risk of liquidation. If the price moves against a trader’s position and the account balance falls below the maintenance margin, the exchange will automatically trigger a partial liquidation, to prevent further losses. For example, a 5% price drop in a position with 20x leverage could trigger liquidation, meaning the trader loses the entire margin for that position.
2. Funding Rate Costs
Since perpetual futures use a funding rate to keep prices aligned with the spot market, traders holding positions for extended periods must account for these periodic funding payments. Over time, funding fees can add up and reduce overall profitability, especially in high-leverage, long-term positions.
3. Volatility
Cryptocurrency markets are known for their volatility, and this can lead to rapid price swings. While volatility can create profit opportunities, it also increases the risk of sudden losses. Traders should closely monitor market conditions and consider using risk management tools like stop-loss orders to minimize exposure to sharp price movements.
Conclusion
Perpetual futures have quickly become a favorite derivative contract for crypto traders looking for flexibility, leverage, and 24/7 market access. Their unique features, such as the exemption from an expiration date and the use of a funding rate mechanism, make them distinct from traditional futures, providing traders with new opportunities to speculate, hedge, and diversify their trading strategies.
However, perpetual futures are not without risks. The use of leverage can amplify both gains and losses, and factors like funding rates and market volatility can impact long-term profitability. For traders who understand these dynamics and employ solid risk management strategies, perpetual futures can be a valuable addition to a trading portfolio.
