What is a Perpetual Swap Contract?
Traders who start crypto futures trading often want to use leverage to boost their profits but worry about losing money if the price moves against them. They may also want to profit from a price drop without selling their coins. This is where Perpetual Contracts come in: Perpetual swap contracts help by letting traders use leverage and take advantage of price changes without an expiration date.
Imagine a futures contract that never ends. You can buy or sell an asset at a predetermined price, but you never have to actually deliver or receive the asset. Instead, you settle the difference in cash. This means you can trade with more capital than you actually have, magnifying your potential profits (but also your losses!). Plus, you can hold your position for as long as you like, without worrying about it expiring.
In this blog post, we’ll dive deeper into how perpetual swap contracts work, their advantages and disadvantages, and how to use them safely.
Key Takeaway
- Understand how perpetual swaps work.
- How to use leverage effectively.
- How Manage risk with funding rates.
What are Perpetual Futures?
The Perpetual Swaps, also called Perpetuals or Perpetual Futures is a form of derivative contracts that gives an opportunity to the traders to speculate on the future price of a cryptocurrency asset without having an expiration date. Unlike the traditional futures contracts which have an expiry date, the perpetual swaps can be held for an indefinite term.
The Perpetual Swaps are crucial financial instruments in the highly volatile world of cryptocurrency that helps to speculate on popular cryptocurrencies like Ethereum and Bitcoin. But, they can also be used for other assets like the indices and the commodities. The Perpetual Swaps are more popular due to their higher degree of leverage and might be more liquid than the spot crypto market.
They offer several advantages to the traders like leverage, hedging and arbitrage opportunities. There are risks and challenges too involved like liquidation, over leveraging and volatility. The funding rate mechanism keeps perpetual futures price aligned with the spot price. It incentivizes traders to take positions that would bring two prices closer together.
When the perpetual futures price is significantly higher or lower than the spot price, funding rate might become more substantial. It encourages the traders to cover the opposite side of the market and reduce discrepancy price.
What are the main features of Perpetual Swaps?
1. No Expiration Date
One main feature of the Perpetual Swaps is the lack of an expiration date. This allows the traders to keep their positions open indefinitely without needing to roll over or close their contracts.
2. Funding Rate
The funding rate mechanism is used to keep the price of perpetual futures close to the underlying spot asset’s price. This rate is paid by one side of the contract to the other side. It depends on the difference between the spot price and the perpetual futures price.
3. Leverage
The perpetual futures allow the traders to use leverage. This helps them control a larger position with a smaller amount of capital. Leverage can amplify both profits and losses. It is crucial to manage the risks appropriately.
4. Margin Requirements
The traders need to maintain a minimum margin balance to keep their positions open. Once the balance falls below the margin requirement, the traders might have to face liquidation, and their accounts are closed automatically to prevent further loss.
How does Perpetual Swaps Work?
The mechanics and working principle of perpetual futures might seem complex. But they are simplified into the following steps.
1. Margin Requirements
To open a position, traders must deposit a certain amount as collateral. This is also known as the initial margin. The margin amount depends on the asset being traded and even on the exchange.
2. Order Execution
Traders can place either a limit or market order to enter or exit a position. Once the order is matched, the trader can enter a position. Consequently, they can profit from the rising or falling of the markets.
3. Funding Mechanism
Perpetual swaps employ a funding mechanism to maintain price alignment with the spot price. This mechanism calculates the funding rate, which is exchanged between the long and short traders at pre-determined intervals. If the perpetual contract’s price is above the spot market price, the long pay shorts, and vice versa.
4. Liquidation
The exchanges employ a liquidation strategy to prevent excessive losses due to leverage. If a trader’s position approaches bankruptcy due to significant price movements, it might be forcibly closed. Here, collateral is used to cover up the losses.
Why Perpetual Swaps Matter?
1. Market Efficiency and Liquidity
Perpetual Swaps play a vital role in enhancing liquidity and market efficiency in the cryptocurrency space. By allowing the traders to speculate on the price movements without having to own an underlying asset, perpetual swaps attract a wide range of market investors. It also includes the high frequency traders and the arbitrageurs. This increased activity contributes to more accurate price discovery and tighter spreads. It ultimately benefits all participants in the market.
2. Hedging and Risk Management
Another crucial aspect of perpetual swaps is their utility in hedging and risk management. The cryptocurrency markets are known for their volatility, and traders often use perpetual swaps to protect their portfolios against adverse price movements. For example, a Bitcoin holder who is fearful of a price drop can open a short position in a Bitcoin perpetual swap to minimize the potential losses.
3. Speculation and Investment Opportunities
Perpetual Swaps provide flexible tool for speculation and investment to the traders. With the ability to trade in the long and short positions, the traders can profit from both the bullish and bearish market conditions. This versatility is very essential for the valuable cryptocurrency market where the price of an asset can increase or decrease significantly.
4. Access to the Cryptocurrency Market
For many investors and traders, perpetual swaps give them a convenient entry point into the cryptocurrency market. Instead of navigating the complexities and securely storing digital assets, traders can simply invest in perpetual swaps on cryptocurrency exchanges. This accessibility lowers the entry barrier and fosters broader participation of traders in the crypto market.
5. Information Flow and Price Discovery
The perpetual swap market often serves as an early indicator of price trends and market sentiments. The traders can closely monitor the perpetual swap data, which includes open interests and fund rates. This helps traders to gain insight into the broader cryptocurrency market. The information flow can be helpful for traders to make informed investment decisions.
Strategies for Trading on Perpetual Swaps
1. Speculation
This involves taking the long or the short positions in perpetual futures contracts based on the trader’s expectation of the direction of the future price of an underlying asset.
For example, if you think that the cost of Ethereum will increase, you can buy an Ethereum perpetual futures contract and make profits from the price increase and vice versa. While speculation is advantageous, it also includes higher risks and requires careful analysis and risk management.
3. Trend Following
The traders can utilise trend analysis to identify the market trends and open long or short positions accordingly. This strategy includes following market’s momentum, entering a position in the direction of the trend, and exiting at the right time when the trend reverses.
4. Hedging
Perpetual swaps can be used to hedge a position in the underlying asset. For example, a trader holding a particular cryptocurrency can sell perpetual futures to protect against potential price drops.
5. Arbitrage
The traders can exploit the price discrepancies between the spot market and the perpetual futures market to make a profit using a particular strategy known as arbitrage. This includes buying an asset in one market and simultaneously selling it in another market to take the advantage of the price difference.
Pros of Perpetual Futures
- They have no expiration date and allows the traders to hold on to the positions indefinitely.
- In some cases, perpetual swaps can have higher liquidity compared to the spot market.
- Leverage allows traders to control large positions with small market capital.
Cons of Perpetual Swaps
- Leverage can amplify both losses and profits and increases the risk for the traders.
- Liquidation risks and margin requirements require careful risk management.
- Funding rates can be costly depending on the market requirements.
Are Perpetual Futures Regulated?
Regulation on the perpetual swaps depends on the jurisdiction as well as the exchange on which you are trading. Some countries jurisdictions might have strict regulations while some other countries might have lenient regulations. Therefore, as a crypto trader, it is important to understand the platform’s landscape to ensure compliance with local laws and regulations.
Conclusion
The Perpetual Swaps are a significant and innovative addition to the cryptocurrency market. Their unique features, like high leverage and no expiry date, make them a valuable tool for crypto investors and traders. Furthermore, the impact of perpetual swaps on liquidity, risk management, and market efficiency should also be considered.
Perpetual swaps empower traders to engage with the dynamic world of cryptocurrencies. It offers both hedging and speculative opportunities. The traders must note that while these derivatives comecome with amazing opportunities, they also have numerous risks.
Mudrex is one of the best crypto trading platforms that is here to support you every step of the way, ensuring that you can explore endless opportunities in the crypto market. Download the Mudrex app from the Play Store now and begin your safe journey in the crypto space.
FAQ
- What is perpetual swaps in crypto?
Perpetual Swaps are a type of derivative that allows the traders to speculate on the future price of an asset without having any expiration date.
- How does perpetual swap contracts differ from traditional futures?
Unlike the traditional futures contracts, the perpetual swaps do not have any expiration date. It enables ongoing trading and continuous exposure to the crypto asset prices with adjustments in the funding rates.
- What role does funding rate play in Perpetual Swap Contracts?
The funding rate adjusts periodically to align the perpetual swap price with the spot market price. It incentivizes traders through funding payments between long and short positions to maintain price parity.
- Why are perpetual swap contracts popular in crypto trading?
The perpetual swap contracts offer flexibility to the traders by allowing them to speculate on the price movements without worrying about the contract expirations, fostering liquidity and enabling efficient risk management in the volatile cryptocurrency markets.
Krishnan is a Bangalore-based crypto writer dedicated to simplifying complex crypto concepts. He covers blockchain, DeFi, and NFTs, with a focus on real-world asset tokenization and digital trust. Previously he has written on Real Estate related assets for NoBroker. Krishnan holds a B.Tech degree from the College of Engineering Trivandrum.
