All you need to know about Perpetual Swap Contracts in Cryptocurrency Trading

  1. Example of Perpetual Contract Trading:

In the cryptocurrency market, a Perpetual Swap Contract is a relatively new trading method. Perpetual contracts are secondary derivatives in which the underlying asset is not owned or traded in the real world.

Conceptually, perpetual contracts are nearly similar to futures trading contracts. Perpetual contracts do not have any expiration (or settlement) date. As a result, traders can buy or sell their contracts at any time and keep them for an indefinite amount of time.

Perpetual contracts are mostly cash settlements equivalent to the asset value, with the exchange acting as the referee in maintaining and executing the contract.

Perpetual contracts were launched on May 13, 2016, allowing traders to take large positions in cryptocurrencies with little money down providing a facility for taking leverage capital gains.

“Long position traders gain profit when the price of the asset moves up, whereas short position traders gain profit when the price of the asset falls.”

Some of the Advantages of Perpetual Contract Trading are compared to Spot Trading:

  • Profit gained in this trading is at the leveraged amount.
  • Returns up to 100 times the invested margin amount.
  • Opportunity for capital gains is in bull as well as a bear market.
  • This contract is just a cash settlement between buyers and sellers with a crypto exchange acting as an intermediary.

Disadvantages of this Trading Method are:

  • Although perpetual contracts are lucrative for investors to gain leveraged returns over a short time, there is a higher risk of losing the entire margin amount in case of loss.
  • Contract positions are liquidated and closed if the asset price falls and the net loss equals the invested amount.
  • Margin amount once loss can’t be recovered since you do not own actual assets.

To understand the perpetual contract, let us know key terms that help to understand its working.

Key terms in Perpetual Contract:

  • Long Position Traders are ones who place buy orders in contracts and gain profit as asset price increases.
  • Short Position Traders are ones who place sell orders in contracts and gain profit as asset price falls.

“Margin: The minimum value you must pay to open a leverage position in the contract.”

Eg: You can buy 1000 BNB (Binance coin) with an initial margin of 100 BNB, i.e; a leveraged contract of 10x (10 times).

This margin amount acts as collateral for the contract. In case of loss, you lose the partial or entire margin amount that you deposited while opening the account.

Through margin amount, one can raise leverage to 100 times depending on risk-taking capacity.

“Maintenance margin: Minimum amount of collateral used to hold and keep the trading position open in the contract.”

Every exchange allocates some maintenance margin from the deposited margin amount that keeps the contract open and up to the fair price of the spot market.

“Funding rate: It is the mechanism that charges some amount to either long or short position traders in the contract when the difference between contract trading price and spot market price arises.”

The funding rate is the percentage of the trading price and either buyer or seller pays to each other in intervals of 8 hours. Typically, the funding rate ranges between positive and negative values.

When the Funding rate is positive, the price of the perpetual contract is higher than the Spot market price and long position traders pay for the short position.

When the Funding rate is negative, the price of the perpetual contract is lower than the Mark price of the contract and short traders pay the long position traders.

This mechanism discourages traders to hold contracts for too long and keeps perpetual contracts close to the spot market price.

“Mark Price: It is an estimated price of a contract that is closely fixed to the spot price.”

Mark Price is decided based on the target of traders for their desired profit margin and is used to show contract value in the market.

Mark price is used to calculate the funding rate.

“Liquidation: This is an event that occurs if traders are in loss and their net loss amount equals the margin amount.”

For long position traders, if the price of the trading contract falls, then depending on the loss and closing position of the contract, part of the entire margin is liquidated to the exchanges.

In the case of short position traders, if the price of the contract rises, then they suffer a loss and their margin is liquidated to exchange for a net loss equal to the margin amount.

To prevent liquidation, the contract must be closed in before loss equals to margin amount.

“Insurance Fund: In case of the extreme volatility of the crypto market, there are chances for traders to lose the entire margin, resulting in unnecessary liquidation.”

In case of rapid price fluctuations, traders may face a negative balance of margin amount in their contracts.

To prevent a negative margin, an insurance fund is applied by the exchange where it pays that negative balance amount and nullifies the contract balance, and liquidates the positions.

An insurance fund is acquired through the pool of liquidized margins from traders and only applies in cases of negative margins.

However, in the appliance of an insurance fund, your balance gets nill and your position gets liquified.

In practice, this occurrence is rare as exchanges have a larger threshold to handle a huge number of transactions in volatile periods.

Example of Perpetual Contract Trading:

Rudra enters a perpetual contract and deposits 1 Bitcoin worth ₹ 38 lakh, and buys 10 Bitcoin at 10 times leverage.

1 Bitcoin which was deposited by Rudra is the margin amount and as collateral of the contract that he holds with an exchange. Rudra is in the Long position of trade.

Rudra hopes that price of Bitcoin will move up from ₹38 lakh to ₹ 40 lakh. Hence, Rudra opts long position (buy order) of 10 Bitcoin at a leverage of 10 times.

On the flip side, Praj expects a bearish market, and the price of Bitcoin may fall from ₹ 38 lakh to ₹ 36 lakh. Hence, he opts short position (sell order contract) of 10 Bitcoin by depositing a similar margin of 1 Bitcoin.

The marked price of a contract is ₹38 lakhs per Bitcoin.

If the price of Bitcoin increases from ₹ 38 lakh to ₹ 40 lakh then Rudra is at a profit of ₹ 2 Lakh per Bitcoin,

Therefore, the profit realised by Rudra = ₹2 Lakh x 10 Bitcoin = ₹ 20 Lakh

Add: Margin = ₹ 38 lakh

Hence, total account value = ₹ 20 lakh + 38 lakh = ₹ 58 lakh

Whereas, Praj has incurred an unrealized loss of ₹ 20 lakh. Hence, calculating total loss:

Total loss for Praj = ₹ 2 lakh x 10 Bitcoin = ₹ 20 Lakh

Remaining margin = ₹ 38 Lakh − ₹20 Lakh = ₹ 18 Lakh

In another case, if the price of Bitcoin decreases from ₹ 38 lakh to ₹ 36 lakh, Praj being in a Short position is in profit of ₹ 20 lakh (10 Bitcoin x ₹ 2 lakh) and can exit the position taking out the margin and profit.

Therefore, the profit realised by Praj= ₹2 Lakh x 10 Bitcoin = ₹ 20 Lakh

Add: Margin = ₹ 38 lakh

Hence, total account value = ₹ 20 lakh + 38 lakh = ₹ 58 lakh

Depending on the price fluctuation and difference between spot market and perpetual contract prices, the funding rate is paid to either the Long or Short position.

The Bottom line:

Perpetual contract trading is one of the advanced trading concepts that combine margin trading and futures contracts with no expiry date.

Perpetual trading being profitable with its huge leverage margins appeals to investors to invest and have lucrative profits.

However, with a huge reward comes a huge risk i.e. losing your partial or complete investment in case of loss.

Hence, it depends on your preference of trading and the perpetual contract is one method where your investment can get leveraged profit in the green rising candle as well as a red candle.

Thank you for reading this article. Any suggestions or corrections are welcomed. Do your research. This article is for educational purposes.