Perpetual futures contracts are an increasingly popular trading tool among crypto users. These derivative instruments open crypto traders to new advantages, including trading with borrowed funds. Perpetual contracts, perpetual futures, and smart contracts are all connected but have their purposes.
In this guide, we will explain their differences, and why traders need to incorporate them into their strategy. Continue reading to learn how futures work, and the benefits you can reap from using them.
What are perpetual contracts?
Most contracts specify dates at which a transaction is carried out. This is to ensure both parties that the exchange will occur. But perpetual contracts work differently.
Perpetual contracts don’t have an expiration date, allowing traders to hold their position for as long as necessary. Perpetual contracts are incredibly useful to traders who want to buy or sell crypto without being bound to a settlement time.
They can act on a short or long position at any time, as long as they maintain their collateral. Since you need borrowed funds, or leverage, to enter a perpetual contract, traders use collateral to keep the position open. The minimum collateral requirement is the maintenance margin.
When a trader exits the position, they can reclaim their margin. Entering the perpetual contract with leverage is needed to keep the trader financially bound to the transaction. If a trader never closes on the contract, they’ll have to surrender the assets they used for collateral.
What are perpetual futures contracts?
Perpetual futures contracts differ from perpetual contracts in that their transaction date is postponed, not undefined entirely. Perpetual futures are also called perpetual swaps and are held between short and long-position counterparties. Futures contracts are a type of derivative instrument, whose value derives from the performance of an underlying asset. Traditional futures do have an expiration date, though.
Perpetual futures give traders an opportunity for more exposure to an underlying asset, like crypto. By using a perpetual swap, traders can also speculate on price movements without outright owning the crypto. Traders buy the contracts instead of the asset - hence why they are underlying assets. Mitigating risk on cryptocurrencies with high leverage is an especially popular use of perpetual futures.
Perpetual futures contracts use the basis of the underlying price index and relative trading volume. Due to this, they’re usually traded very close to market price. Financing makes this possible. Traders pay shorts when the funding rate for their long position is positive. When the funding rate is negative, short parties will pay longs.
The cash flow these payments make up is the funding rate, which incentivizes traders to stay in a perpetual swap. To keep from their balance going negative, traders can also use an insurance fund. This stops any unprofitable trades from piling up by liquidating them. It also ensures the trader receives any owed profits that haven’t gone through yet.
What are smart contracts?
Smart contracts in cryptocurrency are sophisticated code programs that execute based on ‘if/when…then’ statements. When all the ‘if/when’ conditions are met, the smart contract automatically executes the transaction. They allow crypto traders to set up detailed agreements without a third party. This makes blockchains that use smart contracts a lot safer and faster since intermediaries aren’t needed to approve transactions.
Smart contracts can also include as many stipulations as needed, making them customizable. Once a smart contract is agreed on by all parties, it can’t be changed. Additionally, only the parties involved can view the contract’s details, keeping their information safe. Smart contracts are developed by experienced blockchain programmers.
Most traders use online tools provided by their exchange platform to make structuring smart contracts easier. With smart contracts, traders save time on filling out paperwork. Encrypted records of smart contract transactions are also shared on decentralized exchanges. This means there’s transparency on the blockchain, without any sensitive information made public.
Pros and cons of perpetual futures contracts
There are many advantages to using perpetual futures contracts in crypto trading.
Perpetual futures contracts pros
Speculative Operation Opportunities
As mentioned above, traders use perpetual futures to speculate on crypto prices without owning the assets. This minimizes the risk of loss because traders can act on appreciated market prices through their perpetual swaps. This way, the trader profits from the futures sale price. To do so with more volatile cryptocurrencies, traders take higher leverage.
Arbitrage trading takes advantage of different market prices for the same crypto. By buying crypto for a lower price and selling it for a higher in a different exchange, traders make a fast profit. Perpetual futures contracts are a great tool to use for an arbitrage strategy. It keeps risk minimal, as traders can watch for price differences and close a short position at the most convenient time.
Usually, liquidation refers to the conversion of assets into cash. However, perpetual futures contracts have high liquidity in a slightly different way. When positions become unprofitable in a perpetual swap, the trader closes to avoid incurring a negative balance. This can happen pretty often since crypto with high leverage is more volatile. If they suddenly drop, the trader may lose more than the amount of their maintenance margin. This forces all unprofitable trades to automatically liquidate.
A high degree of leverage opens traders up to more opportunities with cryptocurrencies they usually couldn’t afford.
It hedges against volatility risk since traders can profit without owning physical crypto stakes. It also works to help traders avoid the basic risks that come with traditional futures contracts.
Since there’s no expiration date, traders can save time on constantly rolling over old contracts. They also don’t have to spend as much effort in managing their transactions, since the contract executes automatically.
Perpetual futures contracts cons
Funding Rate Costs
When the funding rate for a long position is positive, short parties pay. When it’s negative, long parties pay. While these rewards keep the swap profitable, it also means that traders need to consistently pay for the funding rate costs.
Financial instruments like perpetual futures contracts aren’t tightly regulated. Perpetual swaps are also not authorized by the U.S. Commodities Futures Trading Commission. With a lack of rules in place, victims of bad swaps might not get protection. Defaulters, or those who miss multiple loan payments, may not receive punishment.
The higher your leverage, or borrowed funds, the more you’re risking losing. If a position becomes unprofitable and you don’t have the correct risk measures in place, your losses may amplify. It’s for this reason that traders use an insurance fund to ensure fruitless positions are liquidated automatically.
Decentralized exchanges and perpetual contracts
A decentralized crypto exchange (DEX), is a peer-to-peer transaction platform that cuts out the need for intermediaries. Exchanges are made directly, from one user’s digital wallet to another’s. Uniswap and PancakeSwap are examples of popular decentralized crypto exchanges.
Decentralized exchanges can facilitate secure perpetual contracts through their decentralized protocol. Some DEXs are created specifically for trading with perpetual futures contracts. These DEXs support users seeking out high-leverage positions and make it easier to collect shared revenues.
Perpetual contracts coming soon to WALBI
WALBI is happy to announce that we have plans to add perpetual contracts to our exchange shortly. Our platform is constantly growing and this is just one more step towards WALBI becoming a true, one-stop DeFi solution. Follow our blog and social media to be sure you don’t miss the great news when it arrives!