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Introduction to Perpetual Futures Contracts

Stories of traders achieving extraordinary gains through perpetual futures contracts often dominate crypto discussions, sparking both curiosity and desire for similar success. But what exactly are these instruments that are generating buzz and wealth in equal measure? 

Introduction

Perpetual futures contracts are the mainstay in the crypto trading world. It offers a path to potentially high returns without ever owning the underlying assets. In this blog, we’ll guide you through their mechanics, benefits, and risks. You’ll see how traders use these tools to boost their finances.

Perpetual Futures on CoolWallet

CoolWallet is introducing the integration of Orderly Futures, a robust feature designed to enhance your trading capabilities directly within your wallet. This collaboration brings a state-of-the-art perp DEX, leveraging Orderly Network’s omnichain infrastructure to offer a seamless and secure trading experience.

Key Features

  • Omnichain Perps Trading: Trade perps on multiple chains with up to 50x leverage, directly from your CoolWallet, with secure cross-chain deposits and withdrawals.
  • Enhanced Liquidity: Access Orderly’s shared liquidity model for ample liquidity and tighter spreads across various assets.
  • CEX-like Speeds: Experience low-latency, high-frequency trading speeds comparable to centralized exchanges, while maintaining self-custody and transparency.
  • User-Friendly Interface: Enjoy a customizable, intuitive trading interface provided by Orderly SDK.
orderly network

Orderly Network, the ultimate destination for decentralized trading platforms, aims to make trading easy, fast, and secure for everyone. This partnership means CoolWallet users can engage in perpetual futures trading without transferring assets to a centralized exchange, maintaining control and security over their funds.

What Are Perpetual Futures Contracts?

Perpetual futures contracts, commonly abbreviated as “perps,” are non-expiring, cash-settled contracts that are predominantly used in the cryptocurrency market. Unlike traditional futures, which have specified future payment and delivery dates, perpetual futures contracts do not have an expiration date. This allows traders to hold positions indefinitely, provided they maintain sufficient maintenance margin. Although similar to traditional futures, perpetual futures contracts offer greater flexibility and the potential for leveraging operations. Additionally, these contracts do not require the delivery of the actual traded asset, which is particularly advantageous for assets with low liquidity.

Consider the trading scenario: In traditional futures, Alice buys a January gold futures contract valued at $2,000 for 100 troy ounces, which she is obligated to settle by January. In contrast, with a perpetual futures contract, she could buy 0.05 Bitcoin at a price of $2,000, but without a predetermined settlement time. Thus, Alice can close her position at any time, allowing her to recover her margin as needed. Perpetual futures contracts are appealing in the volatile crypto market due to their lack of expiration and flexible exit timing.

Perpetual futures contracts also offer a high-leverage mechanism, enabling traders to significantly enhance their market positions through borrowed funds without actually holding the crypto assets. This makes them highly suitable for investors looking to hedge risks or speculate on price movements. Daily marked-to-market profits and losses are directly reflected in traders’ margin accounts, providing the flexibility to freely enter or exit trades as desired.

How Do Perpetual Futures Contracts Work?

Perpetual futures contracts let traders speculate on cryptocurrency prices indefinitely, without an expiration date. These contracts utilize a mechanism known as the funding rate to ensure the contract price closely tracks the spot market price of cryptocurrencies like Bitcoin.

Mechanics of the Funding Rate

  • Adjustment: The contract’s price is regularly aligned with the Bitcoin spot price through adjustments made every eight hours using a funding fee. Traders holding long and short positions transfer this fee between themselves depending on their market stance.
  • PnL Settlement: The fee is settled during a process called “PnL settlement,” affecting the traders’ profit and loss accounts.

Long Position And Short Position

  • Long Position Scenario: If a trader, like Alex, anticipates an increase in Bitcoin’s price, he may take a long position by purchasing a perpetual contract. If the market price of the contract is below the spot price, long position holders receive payments from short position holders, encouraging purchasing to elevate the contract price to match the spot price.
  • Short Position Scenario: Conversely, if the contract’s market price is above the spot price, those in long positions pay those in short, motivating sales to lower the contract price to the spot price level.

Trading Example

Suppose Alex believes that Bitcoin’s price is going to rise from its current spot price of $20,000. To capitalize on this potential increase, Alex decides to buy a Bitcoin perpetual contract with 10x leverage.

Initial Setup

Alex invests $1,000 of his own capital to open a position. With 10x leverage, this allows him to control a contract worth $10,000, which corresponds to 0.5 BTC ($10,000 / $20,000 per BTC).

Price Increase Scenario

If Bitcoin’s price rises to $22,000: The value of Alex’s 0.5 BTC increases to $11,000 ($22,000 * 0.5 BTC). Alex’s profit would be $1,000 ($11,000 – $10,000), doubling his initial investment.

Price Decrease Scenario

If Bitcoin’s price falls to $18,000: The value of Alex’s 0.5 BTC decreases to $9,000 ($18,000 * 0.5 BTC).

Alex faces a loss of $1,000, which is the entirety of his initial margin, and his position is at risk of being liquidated if the price drops further or if he doesn’t add more funds to maintain the margin.

Funding Rate Impact

Throughout the trading day, Alex must also consider the funding rate. Suppose the funding rate is positive, indicating that the market expects further price increases. Since Alex is in a long position, he might need to pay a small funding fee to those in short positions if the contract price is higher than the spot price at the time of the funding settlement.

If the funding rate is 0.01% and applies every 8 hours, Alex pays about $1 every 8 hours ($10,000 * 0.01%).

Key Terms Explained

  • Long Position: This means betting on the price increase of a cryptocurrency. For example, buying a contract at $100 and selling at $120 to profit from the price rise.
  • Short Position: This means betting on the price decrease. For example, selling a contract at $100 and buying it back at $80 to profit from the price drop.
  • Leverage: In perpetual futures, leverage acts like a physical lever, allowing traders to control large contract values with a relatively small amount of capital.
  • Initial Margin: This is the collateral deposited to open a leveraged position.
  • Maintenance Margin: This is the minimum amount of collateral required to keep the position open. If the market moves against the position, additional funds may need to be added to prevent liquidation.
  • Forced Liquidation: This occurs when the value of the collateral falls below the maintenance margin requirement, potentially resulting in the account being liquidated to cover losses.
  • Funding Rate: This is a payment made between traders based on the difference between the perpetual contract prices and the spot price. It ensures that the futures price remains tethered to the actual market price of the cryptocurrency.
  • Mark Price:The fair value of the contract used for calculating maintenance margins and avoiding unfair liquidations.
  • Realized PnL: Profits or losses recognized upon closing a position.
  • Unrealized PnL: Profits or losses that exist on paper and fluctuate with the market as long as the position remains open.
  • Limit Order: Allows traders to set a specific price at which they want to buy or sell. The order will only execute if the market reaches or betters that price. This control over transaction prices can lead to delays or non-execution in markets with low liquidity.
  • Market Order: Executes immediately at the best available price, providing the speed of transaction at the expense of potentially large price slippages in thin or volatile markets.

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  • Take Profit (TP): A pre-set price level at which a position is automatically closed to secure a desired level of profit when the market price reaches or exceeds this level.
  • Stop Loss (SL): A pre-set price level at which a position is automatically closed to limit potential losses when the market price falls to or below this level.
  • Insurance Fund: A fund used to cover the losses of bankrupt traders’ positions, preventing further system losses and ensuring profitable traders can exit their positions as expected.
  • Auto-Deleveraging: A mechanism activated in extreme situations where the insurance fund isn’t sufficient to cover all the losses. Profitable traders might sacrifice a portion of their profits to cover these.
  • USDT-Margined: Contracts are settled in USDT, providing clarity on transaction outcomes.
  • Coin-Margined: Contracts are settled in the cryptocurrency being traded, which can vary in value, affecting the actual profit or loss.
  • Cross Margin: In cross margin mode, traders use all assets in their account as collateral for their positions. This approach helps maintain positions longer before liquidation. However, if liquidation does occur, traders risk losing all assets in the account.
  • Isolated Margin: Isolated margin mode allocates separate collateral to each trading position, which is ideal for diversifying risk. If one position is liquidated, it does not affect the others.
  • Open Interest (OI): Indicates the total value of all contracts that remain open and unsettled. High open interest indicates greater market participation and liquidity, typically leading to tighter spreads and more depth in market trading.

Benefits of Perpetual Futures Contracts

Perpetual futures contracts are popular in cryptocurrency trading due to several compelling advantages:

  • No Expiry Date: Traders can hold positions indefinitely without needing to roll over contracts, offering flexibility and continuous exposure to the market.
  • High Leverage: Platforms offer significant leverage, enabling traders to amplify their potential returns using less capital.
  • Funding Rate Mechanism: This feature aligns the contract price with the spot price of the underlying asset. Traders pay or receive funds based on the difference, encouraging fair pricing.
  • Risk Management: Useful for hedging against other investment risks and managing exposure to price movements without owning the underlying asset.

Despite their benefits, it’s important to note that the United States Commodities Futures Trading Commission (CFTC) does not authorize perpetual futures. This means there’s a higher counterparty risk, and in the event of a default, traders may not receive compensation. Unlike traditional futures, where the contract value and the underlying asset price automatically converge as the expiration date nears, perpetual futures require active management to maintain price alignment due to the absence of an expiration date.

Risks Associated with Perpetual Futures Contracts

While perpetual futures contracts offer many benefits, they also come with several significant risks that traders should be aware of:

  • Regulatory Risk: Perpetual futures are unregulated financial instruments. This lack of oversight means there’s no protection for victims of misconduct and defaulters may not face penalties.
  • Complexity and Market Alignment: Perpetual futures contracts require constant adjustment to stay aligned with current market values, making them complex and potentially risky, especially during volatile market conditions.
  • Liquidation Risk: If a trader’s losses reach a certain level and the margin can no longer support the position, exchanges will automatically liquidate the position to protect themselves and other traders.
  • Negative Balance Risk: In extreme market conditions, a trader can lose more than their initial margin, resulting in a debt to the exchange. This is referred to as “debt to the exchange” following a liquidation.
  • Pin Risk: Sudden sharp market moves, or “pins,” can quickly trigger stop-loss orders or cause liquidations before rapidly returning to normal levels. These spikes may be due to low liquidity on exchanges or even market manipulation.
  • Funding Rate Drain: Perpetual contract holders must pay a funding rate every eight hours, which can add up to a significant expense over time, especially with large and long-held positions.

Understanding these risks is crucial for traders to manage their investments prudently in the volatile world of cryptocurrency trading.

Conclusion

Perpetual futures contracts offer an intriguing option for those looking to engage in the crypto market without the limitations of traditional futures. They offer high returns due to their flexible and leveraged nature, but they also carry risks that require careful management. Understanding the mechanics and risks of perpetual futures helps traders make informed decisions and protect their investments. CoolWallet’s integration with Orderly Futures further simplifies access to these complex instruments. It allows users to trade directly from their wallets with enhanced security and control.

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