Perpetual futures, also known as perpetual swaps, are a unique derivative contract that allows traders to speculate on a future price of an asset without an expiration date. They can be held indefinitely, unlike traditional futures contracts. They have increasingly become popular as a financial instrument, especially when it comes to speculating on cryptos such as Bitcoin and Ethereum.

Perpetual futures are popular because of the greater degree of leverage they provide. They are also more liquid than the spot crypto market. They can be compared with perpetual options, which also do not have an expiry date.

What Are Perpetual Futures?

As mentioned before, perpetual futures are a unique type of derivative contract. With it, traders can speculate on the price movements of any underlying asset without having to own or deliver it. This is vastly different than traditional futures contracts, which have a fixed settlement price and expiration date. Perpetual futures are constantly adjusted by the funding rate.

The funding rate mechanism helps align the price of perpetual futures with that of the spot price. It incentivizes traders to take positions that bring two prices together. When the perpetual futures price strays far from the spot price, the funding rate can spike, nudging traders to step in and take the opposite side. This helps to close the price gap and bring things back into balance.

The Mechanics of Perpetual Futures

The main mechanism behind perpetual futures is the aforementioned funding rate. It is a mechanism that ensures that the price of the perpetual futures contract stays close to the underlying asset price (spot).

The funding rate is actually a periodic payment made between the buyers, or longs, and the sellers, or shorts, of the contract. It is based on the difference between the contract price and spot price, similar to what we see in a swap contract.

Depending on the prevailing market conditions, the funding rate can either be positive or negative. When positive, the contract price is higher than the spot price. This is known as contango. In this case, the longs pay the funding amount to the shorts.

When the funding rate is negative, it means the contract price is lower than the spot price. This is known as backwardation. In this case, the opposite happens; the shorts pay the funding amount to the shorts.

Benefits of Perpetual Futures

They tend to have more liquidity since traders are able to enter or exit a position instantaneously. They also allow for trades to be placed at any time without needing to roll over the position.

Then there is the added benefit of trading with leverage, although it can increase potential losses, especially for beginners if not properly guided.

Final Thoughts

Perpetual futures combine the leverage of futures with the prices of spot trading. They are a great instrument for traders to hold their positions for as long as they wish. It is great for both short-term and long-term trading strategies.