What are Perpetual Swaps? How Does it Work?

Key Takeaways

  • Perpetual swaps are a type of derivative contract that allows you to speculate on the future price of an asset (like Bitcoin) without a fixed expiry date, unlike traditional futures contracts.
  • Perpetual swaps are generally more liquid than the underlying asset, making it easier to enter and exit positions.
  • A unique feature is the funding rate, which helps keep the perpetual swap price aligned with the regular market price (spot price) by periodically transferring money between long and short positions based on the price difference.

Perpetual futures, also called perpetual swaps, are a type of trading contract that lets you speculate on the future price of an asset, like Bitcoin or Ethereum, without a fixed expiry date. This differs from traditional futures contracts that have a set settlement date. Perpetual futures are popular in crypto trading because they often allow leverage, letting you control a larger position with less money. This can magnify gains (or losses). They can also be more liquid than the underlying asset, making it easier to enter and exit positions. 

While similar to perpetual options (XPOs) that also lack expiry, perpetual futures require you to fulfill the contract eventually, unlike options that give you the right, but not the obligation, to buy or sell.

What Is a Perpetual Swap Contract?

Perpetual swaps, a derivative product introduced by BitMEX in 2016, have become popular for crypto trading. Unlike traditional futures contracts with expiry dates, perpetual swaps have no settlement date and allow leveraged positions (large bets with a small amount of money down). 

This high leverage can lead to significant profits or losses, making them risky for beginners. Daily trading volumes exceeding $180 billion highlight their popularity but also the potential volatility.

Understanding Perpetual Futures

Perpetual futures are a type of crypto derivative contract that lets you speculate on price movements without owning the asset (like Bitcoin). Unlike traditional futures with an expiration date, perpetual contracts go on indefinitely. A key feature is the funding rate, which constantly adjusts the perpetual futures price to align with the regular market price. This keeps things balanced. 

Perpetual futures are popular due to their high liquidity and the ability to leverage your position (control more with less money). However, be cautious, as this magnifies both profits and losses. They can also be used for risk management, other investments, or exploiting price differences between markets. 

Perpetual Futures and the Funding Rate

A mechanism called the funding rate keeps the perpetual futures price in line with the regular market price (spot price). This mechanism acts like a periodic swap of money between long (buying) and short (selling) positions based on the price difference.

  • When the perpetual futures price is higher than the spot price (contango), long positions pay shorts the funding rate.
  • When the perpetual futures price is lower (backwardation), shorts pay longs.

The funding rate is calculated based on a formula that considers the price difference, an interest rate, and sometimes limits. It’s typically applied every eight hours on most exchanges, directly impacting traders, not the exchange itself. Understanding the funding rate is important for perpetual futures trading, as it influences your profits and losses.

Perpetual Futures’ Key Features

  • Endless Contract: Unlike traditional futures with deadlines, perpetual futures contracts have no expiration date. You can hold your position for as long as you see fit.
  • Funding Rate Magic: This mechanism keeps the perpetual futures price aligned with the regular market price (spot price). It’s a periodic exchange of money between long and short positions based on the price difference.
  • Leverage Power: These contracts allow leverage, letting you control a larger position with less capital. Remember, bigger gains (or losses) come with this power!
  • Margin on the Line: To maintain open positions, traders need to have a minimum margin balance. Falling below this threshold can trigger liquidation (forced closing of your position) to manage risk.

Perpetual Futures Strategies

Perpetual futures offer a toolbox for various trading strategies:

  • Speculation: Bet on price movements. Buy a contract if you think the price will rise (long), or sell if you think it will fall (short). This high-risk, high-reward strategy requires careful analysis and risk management.
  • Trend Following: Ride the wave. Use technical analysis to identify trends and capitalize on them. Enter long positions in uptrends and short positions in downtrends, exiting when the trend reverses.
  • Hedging: Protect your assets. If you already hold an underlying asset (like Bitcoin), you can sell perpetual futures contracts to hedge against potential price drops.
  • Arbitrage: Exploit price differences. This involves buying an asset in a cheaper market (spot market) and simultaneously selling it in a higher market (perpetual futures market), pocketing the profit from the discrepancy.

Are Perpetual Futures Regulated?

Perpetual futures regulations depend on your location and the exchange you use. Some countries, like the US, have regulatory bodies (CFTC) overseeing them. However, many crypto exchanges offering perpetual futures operate in areas with less strict rules. As a trader, it’s critical to understand the regulations of your chosen platform and ensure you comply with local laws.

Final Thoughts

Perpetual swaps are a game-changer for crypto traders. They allow traders to hold positions forever, unlike traditional futures with deadlines. High liquidity makes entering and exiting positions easier. But beware as complexity awaits. The funding rate keeps things fair, but leverage can magnify both wins and losses. This makes them risky, especially for beginners. Use perpetual swaps with caution and a trading strategy. Remember, research, manage risk, and choose a compliant platform. Trade wisely and unlock the potential of perpetual swaps in the dynamic crypto market.

Via: 2Usethebitcoin.com

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