Understanding Perpetuals in Crypto Trading

Cryptocurrency trading is now mainstream, with many people familiar with it and eager to participate due to FOMO (fear of missing out) and potential financial gains. As the market evolves, advanced tools like perpetual contracts have emerged, offering traders more options and the potential for greater profits.

Perpetuals are derivatives that allow leveraged trading, enabling traders to use borrowed funds. Derivative in crypto involves buying and selling financial contracts whose value is based on underlying cryptocurrencies; perpetual and futures trading are examples of derivatives.

Despite the complexity of Perpetuals and the target audience of experienced traders, they offer significant advantages. This article explains perpetuals, covering their definition, history, key terminologies, benefits, and drawbacks.

What Exactly Are Perpetuals?

Perpetual contracts, also known as perpetual swaps or perpetual, are derivatives in cryptocurrency trading. Unlike traditional futures contracts, perpetual contracts do not have an expiration date, allowing traders to hold positions indefinitely.

A futures contract is a derivative instrument with a set expiration date linked to an underlying asset such as Bitcoin (BTC). When the contract expires, the positions are settled. In contrast, perpetual contracts do not expire, and traders can keep their positions open if they maintain the required margin.

Perpetual contracts offer benefits like leverage, hedging, and arbitrage opportunities, making them highly popular, with billions of dollars traded daily. However, they also involve risks such as volatility and liquidation.

These contracts maintain their price close to the underlying asset through funding rates: positive rates mean long traders pay short sellers, while negative rates mean short sellers pay long traders. This mechanism ensures that perpetual contracts trade close to the spot price of the underlying asset.

When Did Perpetual Futures Initially Surface?

The concept of perpetual futures was first proposed by Robert Shiller in a 1993 study, aiming to use derivatives for illiquid assets such as real estate. For example, a home generating rental income can serve as the underlying illiquid asset. The primary goal of perpetual futures is to facilitate price discovery for assets with illiquid or hard-to-measure prices.

Perpetual futures entered the cryptocurrency space around 2011 when Alexey Bragin created a type of "inverse perpetual" for the ICBIT exchange. The adoption of perpetual futures in the crypto world expanded significantly in 2016 when a cryptocurrency and derivative exchange, BitMEX, introduced the first perpetual swap contract. This innovation made perpetual futures more widely known and utilized in the cryptocurrency market.

Currently, ReHold is building the first decentralized finance (DeFi) Bitcoin perpetual with an AI assistance tool. With this, ReHold will bring more opportunities for traders while further innovating and expanding the use of perpetual contracts in the cryptocurrency space.

Key Elements of Perpetual Contracts

To understand perpetual contracts well, it's essential to know some key terminologies.

1. High Leverage: Perpetual contracts often provide high leverage, allowing traders to control large positions with a relatively small initial investment. This leverage amplifies both potential gains and losses, making it possible to achieve significant returns with limited capital. However, it also increases the risk of substantial losses.
2. No Expiration Date: Perpetual contracts do not have a set expiration date, allowing traders to hold positions for as long as they choose. This flexibility enables traders to maintain their positions indefinitely without the need to roll over contracts, unlike traditional futures, which expire on a specific date.
3. 24/7 Trading: Perpetual contracts are traded on cryptocurrency exchanges that operate around the clock, providing continuous market access. This 24/7 trading environment allows traders to react to market developments anytime, offering greater flexibility and opportunities to capitalize on price movements without being limited by traditional market hours.
4. Margin Requirements: To open and maintain positions, traders must meet margin requirements, a portion of the position's value that must be deposited as collateral. If the position's value moves against the trader and the margin falls below a certain threshold, the position may be liquidated to prevent further losses. Understanding margin requirements is crucial for managing risk and avoiding liquidation.
5. Funding Rate: The funding rate is a periodic payment exchanged between long and short positions to keep the perpetual contract price close to the underlying asset's spot price. This rate is calculated based on the difference between the contract price and the spot price, ensuring that the contract price does not deviate significantly from the market value of the underlying asset.

Benefits of Perpetual Contracts in Crypto

1. Continuous Trading: Unlike traditional futures contracts, perpetual contracts have no expiration date, allowing you as a trader to hold positions indefinitely.
2. High Leverage: Perpetual contracts often offer high leverage, enabling you as a trader to control large positions with a relatively small amount of capital.
3. Liquidity: Popular perpetual contract markets tend to have high liquidity, resulting in tighter spreads and better execution prices for you as a trader.
4. Hedging: These contracts provide an effective way for a trader to hedge against price fluctuations in the underlying asset without worrying about contract expiry.
5. 24/7 Market: Crypto markets, including perpetual contracts, operate 24/7, giving you as a trader the flexibility to trade at any time.
6. Funding Rate Mechanism: The funding rate helps maintain the contract price close to the underlying asset's price, preventing large deviations and ensuring market stability for you as a trader.

Drawbacks of Perpetual Contracts in Crypto

1. High Risk: The high leverage can lead to significant losses, potentially exceeding your initial investment as a trader.
2. Funding Rate Costs: Traders must pay or receive funding fees periodically, which can add up over time and affect their profitability.
3. Liquidation Risk: Using leverage increases the risk of forced liquidation if the market moves against your position as a trader.
4. Complexity: Understanding and managing the risks associated with perpetual contracts can be complex, requiring you, as a trader, to have a good grasp of margin, leverage, and funding rates.

Balancing these benefits and drawbacks is important for any trader considering perpetual contracts as part of their crypto trading strategy.

Conclusion

Perpetual futures offer traders a unique opportunity to speculate on asset prices without the constraints of expiration dates. With features like leverage and continuous trading, they can be an attractive choice for those looking to profit from market trends or manage positions.

However, it's important to understand the risks, including margin requirements and leverage, and to employ sound risk management strategies. This financial product can be valuable if you are willing to accept these risks and have a solid understanding of perpetual futures principles. As with any investment, always Do Your Own Research (DYOR) and thoroughly understand the market before engaging in perpetual futures trading.