Introduction to Bitcoin Perpetual Contracts
A perpetual contract is a contract that allows a person to purchase or sell an asset at a set price and date, similar to a futures contract. For the uninitiated, futures are a type of derivative that gains value based on their underlying assets.
Let’s say a contract states that 1 BTC can be sold for $30,000 on July 31st, 2021. Given that the price and expiration date are predetermined, this is a future. The contract can be traded until the expiration date, allowing traders to speculate about Bitcoin’s price before its expiration. Therefore, the prices of futures contracts can significantly deviate from the spot trading price of related assets.
A perpetual contract is similar to a future, but it does not have an expiration date or a settlement date; therefore, it can be held and traded indefinitely. Recently, perpetual contracts have gained a lot of traction since they allow traders to retain leveraged positions without worrying about an expiration date. Perpetual contracts are typically traded using an underlying Index Price, which is the average price of an asset, based on main spot markets and their proportional trading activity.
Perpetual financing rates are the primary mechanism that provides stability for perpetual contacts, allowing them to trade close to the index price of the underlying asset, unlike futures. The primary purpose of perpetual funding rates is to assign a monetary value to any differences between the perpetual contract and the target price determined from the underlying asset.
This article will cover all the essential things you need to know about Bitcoin perpetual contracts. But before we get to that, let us look at some commonly used words in “Bitcoin Perpetual Contracts Trading”.
Common terminologies in Bitcoin Perpetual contracts trading
- Initial margin — The initial margin is the minimum amount a trader must pay to open a leveraged position. Basically, the initial margin serves as collateral for a trader’s leveraged position. For example, a trader can buy 1,000 BTC with an initial margin of 100 BTC (at 10x leverage). As a result, the trader’s initial margin would be 10% of the total order value.
- Maintenance margin — The minimum amount of collateral that a trader needs to hold to keep their trading positions open is known as maintenance margin. When opening a position in perpetual contracts, the maintenance margin base rate is 0.5% for BTC and 1% for ETH, EOS, and XRP of the contract value. As the risk limit changes, this will increase or decrease proportionally.
In summary, the initial margin is the amount a trader contributes when they create a position, whilst the maintenance margin is the minimum balance required to keep their positions open.
- Funding rates — Funding rates are periodic payments made to long or short traders based on the difference between the perpetual contract market and the spot price. Most cryptocurrency derivatives exchanges use funding rates for perpetual contracts.
As we stated earlier, long traders (contract buyers) must compensate short traders (contract sellers) when the funding rate is positive. A negative funding rate, on the other hand, means that short positions pay longs. While the funding rate calculations are usually made up of two parts, the interest rate and the premium, index price and mark price are the two primary price concepts for funding rates.
- Interest rate — The interest rate is usually fixed and is determined by the underlying assets from which the perpetual derives its value.
- Premium — The premium component is used to calculate the difference between the perpetual and mark prices.
- Index price — The index price represents the underlying asset’s average spot price across numerous exchanges.
- Mark price — When compared to the actual trading price (last price), the mark price is an estimate of a contract’s actual value (fair price). When the market is highly volatile, the mark price calculation prevents unfair liquidations. In short, the mark price, which is generated from the index price, is the primary reference point for computing the funding rate.
Bitcoin Perpetual Contracts
Bitcoin perpetual contracts, also known as perpetual swaps, are a prevalent type of futures contract. Owing to its massive leverage, the introduction of perpetual swaps in the Bitcoin derivatives market was welcomed with much acclaim.
Several well-known exchanges, for instance, offer 100x leverage on perpetual contracts, thereby allowing traders to open positions worth 100 BTC in swaps contracts with a 1 BTC margin deposit. Given how Bitcoin perpetual contracts don’t have any settlement date, there is no obligation for either party to buy or sell. Instead, traders can keep their positions open for as long as their account (margin) allows.
Benefits of Bitcoin perpetual contracts
There are various advantages to trading Bitcoin perpetual contracts. Most importantly, they provide traders with a simple way to hold leveraged positions in a market with no expiration date. Additionally, investors can earn interest while mitigating risk from the underlying asset by taking advantage of perpetual funding rates.
Bitcoin perpetual contract trading, unlike spot trading, also allows traders to make both short and long trades. As a result, traders will not be trapped with a losing position even in a bear market. Weekend trades are also unaffected because cryptocurrencies are not affected by national or bank holidays. Exchanges are only shut down for scheduled maintenance, which traders are informed about ahead of time.
The allure of Bitcoin perpetual contracts is further enhanced by the fact that they offer significant leverage. Some exchanges even offer up to 100x or more leverage on perpetual contract trading, attracting lots of investors. With Bitcoin perpetual contracts trading, several investors, especially beginners, have the opportunity to start small and gradually build their portfolio over time with profit maximization.
How do Bitcoin Perpetual Contracts work?
Let’s say a perpetual contract is for $10,000, but the spot price of BTC is worth $10,005.
When you account for the price difference, the funding rate will obviously be negative. A negative funding rate, in general, indicates that the short holders must pay the long holders. If the contract price is higher than the spot price, the funding rate will be positive, implying that long-term contract holders must pay short-term contract holders.
In both cases, the funding rate usually encourages opening new positions, bringing the contract’s price closer to the spot price. As long as contract holders keep their positions open, funding rate payments are made every eight hours on most exchanges. On the other hand, profits and losses are realized at the end of each trading day and automatically credited to account holders.
Data on funding rates is a valuable tool for quickly assessing market trends and performance over time. A positive funding rate generally indicates that the market is generally more bullish, whereas a negative funding rate indicates that the market is generally more bearish.
Bitcoin Perpetual Contracts vs Bitcoin Futures
Because settlements are made in BTC rather than USD, perpetual contracts settlement of BTC/USD futures is often referred to as an “inverse future contract” in the Bitcoin industry. While Bitcoin futures have long been the most popular type of cryptocurrency derivative on the market because they allow traders to speculate on future Bitcoin prices and profit based on the accuracy of their predictions, Bitcoin perpetual contracts are rapidly becoming the most popular type of cryptocurrency derivative on the market.
Here are the main reasons why traders are now choosing Bitcoin perpetual contracts over Bitcoin futures.
- In theory, a futures contract, as stated at the beginning of this article, is essentially an agreement between two counterparty agents to purchase or sell a financial instrument or commodity at a predetermined price on a future date. Upon expiration, the buyer or seller must fulfill the terms of the agreement by buying or selling regardless of the underlying asset’s price. However, in reality, most traded futures are non-deliverables, which means that the difference must be covered and no delivery occurs.
- Furthermore, unlike futures, Bitcoin perpetual contracts are traded on the basis of the underlying Index Price; therefore, they are traded at levels that are incredibly close to spot markets. Because Bitcoin perpetual contracts do not expire, traders benefit from not having to repeat the opening action every time they trade.
- Transaction costs are also much lower for Bitcoin perpetual contracts since settlements are settled in BTC rather than USD. While a standard bank transfer can take up to two days to complete and is subject to fees as the money goes from one bank to another, BTC transactions are made from one wallet to another, and geographical distances are irrelevant because payment aggregators are not used. The use of BTC instead of USD for settlements also allows several regulatory barriers concerning fiat deposits on exchanges to be avoided.
For reasons such as these, several traders prefer Bitcoin perpetual contracts to futures. The increased usage of Bitcoin perpetual futures is an indication of the crypto market’s maturation and allows for considerably more efficient price discovery.
Bitcoin Perpetual Contracts: The Way Forward
Bitcoin derivatives, particularly Bitcoin perpetual contracts, are an excellent way for investors to expand, mature, and profit as institutional money increasingly appears set to enter the cryptocurrency markets. Perpetual contracts are undeniably an advanced method for no-expiry futures contracts directly in Bitcoin, and their growing popularity among various exchanges demonstrates their long-term viability in the market.
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