Ethereum Perpetual Contracts 101
With the advent of Decentralized Finance (DeFi) in the crypto sphere, the interest of varied institutional and individual investors in a new crypto asset class, i.e., derivatives, has started looking up at crypto exchanges. Institutions, especially, prefer the derivatives mode to access the cryptocurrencies to hedge their funds while trading in volatile crypto markets. There are several kinds of derivatives that exchanges currently offer including futures, forwards, options, swaps and others.
Futures, a type of derivatives, are an arrangement whereby the two parties commit to executing the actual trade of their assets on a future date at a pre-decided price. By utilizing the power of leverage, futures help you to maximize returns by:
- multiplying your profits,
- minimizing market risk, and
- using advanced trading strategies such as Perpetual Futures while holding relatively less crypto(In this case Ethereum or ether) in comparison to that in spot trading.
Ethereum (ETH) is the second-largest cryptocurrency by market cap. It is designed to support decentralized applications on its platform and for writing smart contracts on its blockchain. Ether’s primary function is to act as a means of paying the transaction fees and more recently, has become popular serving as collateral for borrowing specific ERC-20 tokens in the DeFi sector.
Before we begin with our Ethereum Perpetual 101 guide, you need to understand the difference between an Ethereum Future Contract and an Ethereum Perpetual Contract.
A Futures contract is a binding contract between the buyer and seller where they are obliged to buy and sell a commodity on the predetermined date irrespective of the price of the commodity on that particular day. While Perpetual Futures Contracts are an advanced agreement between the buyer and the seller with no specific expiry date. It is for the buyer and the seller to decide when they want to execute the contract. Perpetual Futures allow for macro position-taking and risk management to the traders.
#1 What are Ethereum Perpetual Contracts?
Ethereum Perpetual Contract or any futures or perpetual contract as such, derives its value from the underlying currency of the contract, in this case, Ethereum. The price of the contract is a direct consequence of the price shifts in Ethereum.
Let’s read some more about the no-expiry Ether futures further:
- The buyer and seller bound in a perpetual contract can hold the position for as long as they want to.
- Perpetual futures trading takes place based on the Index price of Ethereum. The index price is calculated using the average asset price and the corresponding trade volume of that particular asset price.
- A buyer can decide to buy Ether if they expect the prices to rise in future while a seller can initiate the contract if they think the prices would fall in the future.
- Like Futures, perpetual contracts have in-built leverage that multiplies the returns. The buyers and sellers are free to take long or short positions on Ether based on their risk profile and judgement.
- Perpetual futures allow for trading profitably in both the bull and bear markets, unlike spot trading which only benefits traders in the bull run.
Note: A short position lets you earn profits by buying the asset at a low price when the market goes down, while a long position lets you earn profits by selling it at a higher price when the market goes up.
#2 What are the Margin Requirements for ETH Perpetual Contracts?
There are two kinds of margins involved in Ether Perpetual Contracts, namely, Initial Margin and Maintenance Margin. Initial margin is the minimum amount a trader is required to pay to open a leverage position in Perpetual Future Contracts. This is called margin trading. Under margin trading, a trader can trade more than what they are eligible for, by depositing their collateral instead of the margin amount in their margin account.
Once eligible, the trader starts trading. After completion of the trade, the trader returns the margin amount along with the interest.
Maintenance margin is the minimum balance a trader should maintain in their margin account to keep trading. The maintenance margin value varies with the change in the market price of the collateral.
If the balance falls below the prescribed limit, the margin account will be liquidated. If the trader doesn’t meet the maintenance limit despite repeated margin calls, their account will be suspended, the remaining amount returned and a nominal fee deducted from their margin account.
#3 How do Traders Determine Their Profit and Loss in ETH Perpetual Contracts?
Traders should be aware of the Mark Price or the actual estimated value of their futures contract concerning the current trading price of Ether. Mark price helps the traders in preventing account liquidation in the future. Traders use the Mark Price to calculate the accruing profit and loss, i.e. the unrealized PnL during an open position in the Perpetual Futures market. The number keeps on changing till the position closes and the PnL becomes realized.
#4 How do Traders Initiate Funding while Going Long or Short in ETH Perpetual Futures?
In a Perpetual Futures Contract, like a futures contract, a buyer holds the long position by committing to buy Ether at a particular price while a seller holds a short position by agreeing to sell Ether at a predetermined price in future.
The payment process that happens between the buyer and the seller is called funding. When there is a positive funding interest, i.e., the funding rate is above zero, buyers ‘going long’ pay the sellers ‘going short’. While, in case, the funding rate falls below zero which means a negative funding rate, the sellers pay the buyers. Similarly, when ETH Perpetual Contracts are being traded at a premium rate, the funding rate is positive. In this case, the buyers pay the sellers making way for new short positions.
#5 What Relevance do Insurance Funds Have in ETH Perpetual Futures?
If a buyer going long fails to close their position due to a market price drop or some other reasons, their account will be liquidated as soon as the balance falls below the minimum prescribed limit. The insurance fund in the ETH Perpetual Contract provides an additional hedge for safeguarding the trader’s account and their collateral against liquidation.
The Insurance fund keeps accumulating the collaterals deposited by the traders who fail to close their position owing to a price drop and their accounts getting liquidated. The fund is used to cover the losses incurred due to these open positions of the bankrupt accounts.
In case the insurance funds prove insufficient to recover the liquidation losses incurred, the traders who have earned a profit are required to shell out a part of their profits for meeting the losses. This method is called auto-deleveraging. However, it is a task to identify traders in the auto-deleveraging queue in Perpetual Futures Contracts.
In the highly volatile and variable crypto trading world, Ether Perpetual Contracts are proving to be the most beneficial instruments of trading while preventing the associated risks with futures contracts. Several cryptocurrency exchanges provide futures and perpetual contracts as trade instruments on their platform given their increasing popularity and scope. If you are keen on cryptos but fear directly trading in them, buck up and invest in Perpetual Futures!