If you wonder how traders are able to maximize their returns in cryptocurrency, one instrument that allows this are perpetual swap contracts (i.e. perpetual contracts). These are derivative products offered by digital exchanges, with data showing daily trading volumes reaching greater than $1 Billion. It was launched by the Bitmex exchange on May 13, 2016 and has since increased in popularity.
Perpetual contracts offer traders an opportunity to get massive returns, even with the least amount of input. This allows opening large positions that gain on small movements in the market. Although you can 100x with leverage on these products, the risks are enormous.
Traders can hold their position indefinitely but they must maintain the required margin. If they do not maintain it, they can get rekt on their position, which can lead to a large amount of losses.
Speculation On Price Movements
A perpetual contract is similar to a futures contract. Traders speculate on the future price of an asset, but unlike futures contracts a perpetual contract does not have an expiration date. That means there is no need to adjust a position (long or short) in an open trade.
Exchanges implement a price anchoring mechanism called a funding rate. This balances established positions by incentivizing trades. It can also disincentivize a trade by closing it if it fails to maintain its margin.
The Funding Rate
The need to create a funding rate is in order to align the perpetual contract price with the asset's spot market price. In the crypto market, the spot price is the market price across exchanges. If the price of an asset on the market is $30,000, then the perpetual contract must also price it at that level or close to it.
There are those who are speculating that the price of an asset will go up and these traders hold a long position. Those who are on the opposite end who hope for prices to go down are holding a short position.
The funding rate is positive if the price of a perpetual contract is above the spot price of the asset. The asset is trading at a premium so those holding long positions must pay funding to short positions. When the funding rate is negative, short positions must pay the long positions.
This mechanism helps to correct deviations in prices so that they maintain a balance. If the price diverges too much from the spot price, then it will not be fair to traders since it varies from the rest of the market. The funding rate is a way to stabilize prices.
Trading Scenario 1 (Perpetual Price > Spot Price)
Let's say the price of Bitcoin (BTC) reaches $100,000 at the spot market price. The perpetual contract price is at a $1,000 premium at $101,000. For simplicity's sake, let us say the funding rate is 0.01%.
BTC (Perp) = $101,000
BTC (Spot) = $100,000
r = 0.01
To bring the perpetual contract price closer to the spot price, the funding payment is:
$101,000 * 0.01 = $1,010
Long positions pay the funding rate to those that hold short positions. This is to incentivize traders to take the opposite position which helps to keep the contract price balanced.
Trading Scenario 2 (Perpetual Price < Spot Price)
The price of Bitcoin (BTC) is $100,000 at the spot market price. The perpetual contract price is at a $1,000 discount at $99,000 ($100,000 - $1,000). The funding rate is at 0.01%.
BTC (Perp) = $99,000
BTC (Spot) = $100,000
r = 0.01
To balance the price the funding payment is:
$99,000 * 0.01 = $990
A funding payment is made by those holding a short position to those with a long position.
Perpetual Swaps
Traders make gains from a perpetual contract through swaps.
A trader can open a long position by depositing collateral to a perpetual swap contract. If the swap is worth $10,000 each, and the trader buys 2, then the total deposit required for the collateral is $20,000. Since there is no expiration, the trader can hold on to it for as long as they like and sell it in the future when the price is higher.
The trader must still pay the funding rate in order to hold their position, so the given examples are just theoretical.
If the price of the contract increases to $12,000, then the trader has made the following profit:
P = 2($12,000 - $10,000) = $4,000
The trader can also take advantage of using leverage to get higher returns to multiply profits. Supposed the trader goes on 2x leverage, that would put the position at $40,000 even though the collateral is worth half of that. If the trader closes the trade at a swap price of $12,000, the expected return on profit will be $8,000.
There is a liquidation risk from going high on leverage (depending on the exchange). When the swap price falls by half or 50%, then the trader will be at a loss.
L = 4($5,000 - $10,000) = $20,000
The trader will be at a loss of $20,000. At this point exchanges will close the position when the losses equals to the collateral deposited.
High Risk, High Rewards
The cryptocurrency market is very volatile, so the price swings can take huge dips that lead to massive losses. With perpetual contracts, there is the possibility of making profits even when the market prices are falling.
Perpetual contracts have no time constraints, allowing traders to maintain a position for as long as they like or before getting liquidated. That means less hassle for traders since they do not have to be concerned about expiration dates.
One thing to note is that these financial instruments are custodial if used on centralized exchanges. This means that the collateral deposited is transferred to the exchange, and the trader no longer has custody of their assets. That is another part of the risk, because if something were to happen to the exchange (e.g. hack, rug pull) the trader could lose their deposited assets.
The gains from perpetual contracts can be enormous, but it is highly risky. It has the means to multiply losses, but it can also multiply profits. This adds to their appeal in the cryptocurrency trading market, but proceed with caution.
Disclaimer: This is not financial advice and is the author's opinion. The information provided is for reference and educational purposes only. Please DYOR to verify information.
