Have you ever come across the name ‘perps’ in crypto? Or heard of perpetual futures contracts but are even more confused? Well, we will bring some clear understanding to you for what these terms mean, and how these trading instruments could benefit you in trading cryptocurrency. In this blog post, we will explain futures in an easy-to-understand way, and use clear examples that anyone can follow.
Perpetual futures contracts in crypto are a type of derivative that allows traders to take positions on the future price of cryptocurrencies without an expiration date. Traders can open both long (bullish) and short (bearish) positions with leverage, while perpetual contracts use a funding mechanism to keep their prices aligned with the underlying asset’s spot market price.
What Are Crypto Derivatives?
To start, we have to know what crypto derivatives are. Well, crypto derivatives are financial instruments derived from cryptocurrencies. All derivatives are derived from the ‘underlying’ product, in this case cryptocurrencies.
They derive their value from the underlying cryptocurrency and can be used as contracts between two parties to speculate on the future of this underlying cryptocurrency. In short, derivatives allow speculators to gain exposure to crypto and tokens without actually owning them.
What Are Futures?
A futures contract is a type of, said crypto derivative, that involves an agreement between two parties to either buy or sell cryptocurrency at a predetermined price in the future. When these contracts are bought, the parties agree on the price and the expiration date of the contract, which will be settled when the expiration date comes.
If the price of the underlying cryptocurrency goes up, the buyer of the futures contract makes a profit, and if the price goes down, the seller of these contracts makes a profit.
It’s like placing a bet on the future value of cryptocurrency X without actually owning it.
Example of Futures Contracts
We look at an example to illustrate how these futures contracts work.
Suppose there are two traders, Hans and Francis, who both enter into a futures contract locking the price, when the price of Bitcoin is $35,000, meaning the contract is agreed upon that at expiration the BTC is sold at this price. Hans strongly believes that the price of Bitcoin will pump, while Francis believes it will dump.
If the price of Bitcoin goes up to, let’s say, $40,000, Hans will have a nice profit by purchasing Bitcoin from Francis at a discount. He can sell it in the market for a higher price and make a profit, pocketing $5,000.
But let’s say there is bad news and the market tanks, and the price of Bitcoin goes down to $30,000, Hans will still have to buy Bitcoin from Francis at the agreed price of $35,000, which results in a loss for Hans, and a profit for Frank.
What Are Perpetual Futures Contracts?
Here comes the innovation of crypto, yet again: ‘perpetual contracts’. These everlasting contracts are another type of crypto derivative similar to futures. But here is a distinct difference, as these types of derivatives have no expiration date.
Speculators can hold their positions for as long as they want, into perpetuity. So perpetual futures contracts, often called crypto perps, are derivatives that trade close to the asset’s underlying price but don’t expire.
How do they stay so close at the price of the underlying? To ensure that perpetual futures contracts are traded at prices close to the spot market prices, they have a price peg mechanism that is maintained through a funding payment between contract sellers and buyers. On top of the fee for opening such a contract, whether this is buying or selling, traders have to deal with the funding fee, which ensures the price of futures is close to the spot market price.
Example of Perpetual Contracts
Let’s consider the example from above, where Hans is still bullish and invests in perpetual futures contracts and he buys this ‘perp’ when the price of Bitcoin is around $35,000. Now imagine that, after two minutes, two days, two months, or even years, the price of Bitcoin goes up because of ETF news. Hans decided to take a profit and close his position to realize a profit of $5,000. See that perpetual contracts do not have any settlement dates and can be held for as long as he wishes.
The reason perpetual futures and other derivatives for that matter, are important for us traders and speculators is because these crypto derivatives offer leverage opportunities. So what is leverage exactly?
Leverage allows traders to open positions that are larger than their initial trading capital. If a derivative exchange offers 5x leverage, Hans’s capital would multiply by five, resulting in potentially higher profits. But, and this is a big ‘BUT’, this will also mean the inverse, his leverage will amplify his losses if he is on the right side of the market.
This means a big risk and the result of him being liquidated if the market moves against him. Liquidation means a forced foreclosure of your position plus an additional liquidation fee on top of that. Many players have been liquidated totally and lost it all! Please don’t be one of them.
Benefits of Cryptocurrency Perpetual Futures
Well, these trading instruments that are offered by many exchanges can be helpful for traders who know what they are doing. First of all, they provide an opportunity to profit in both bullish and bearish markets. Because it lets people who buy the contract earn a profit if prices go up and vice versa, it lets them earn when prices go down and they are short, meaning they sold the contract.
Another reason why these futures could be beneficial is because they allow investors to trade crypto without actually owning it. Hereby reducing the risks associated with storing and securing digital assets in one of the wallets. Which could be complex for big institutions that want exposure to the valuation of cryptocurrency.
Lastly, an argument for futures is that it provides liquidity to the market, thereby facilitating a smoother price discovery for multiple speculators. Those who think prices will crash will now have an instrument to place their bets and in some cases hedge their positions.
Risk Management Crypto Perpetual Futures
Perpetual futures play a crucial role in managing traders’ risks that are associated with holding cryptocurrencies. A way to manage risk is to seize the opportunity to hedge your positions and offset potential losses.
For example, if Hans holds spot market Bitcoin, safely stored in his wallet and the price starts tanking, he can sell a derivative contract that locks in the price, offsetting his losses, in the future.
This is done by many miners who want to lock the price and purchase futures contracts to hedge their costs of mining crypto.
Another great risk of futures contracts is the highly volatile nature of these markets. This volatility, unseen in traditional markets means and has meant many devastating losses. Small liquidity and liquidation cascades let the price jump, resulting in a safe position with enough margin to a liquidated position in a matter of minutes, even seconds if flash crashes were to happen.
Solutions have been built for protecting speculators from this but many have lost it all in the process. Finally, it’s important to choose a reputable and regulated trading platform to ensure the safety of your funds and open trades. Known out of past reports, exchanges do not shy away from trading against their customers from one of their trading desks.
In summary, perpetual futures are a derivative market of cryptocurrency, meaning that you trade in contracts and not in cryptocurrency directly. Futures contracts involve buying or selling any of these contracts at a predetermined price in the future and will be settled, at the agreed price when this time arrives.
In contrast, perpetual futures contracts have no expiration date and can be held in theory until the end of the day. What is attractive are the leverage opportunities these contracts bring with them, but let this be a warning not to get burned because trading futures can be similar to playing with a gun. If you don’t know what you are doing you will be liquidated sooner than later.