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The Fundamentals of Crypto Perpetual Contracts

Edwin Munyui
Head of Content
April 12, 2021

Drixx Fundamentals of Perpetual Contracts

The crypto market is on a steep growth trend and seems to be attracting more stakeholders on a daily basis. A few years ago, Bitcoin was the only cryptocurrency and was being traded via peer-to-peer networks only. This has since changed following the debut of cryptocurrency exchanges - they now facilitate most of the crypto trading activity.

As the market gradually came of age, more products popped up to suit the different types of investors or traders. Today, there is a wide range of crypto assets that one can purchase or trade in the existing marketplaces. They include sophisticated instruments such as crypto derivatives which have become popular market tools in recent years.

Some of the most commonly traded instruments are futures, forwards and perpetuals - their value is determined by an underlying crypto asset such as Bitcoin or Ether. In this article, we will focus on the different types of crypto perpetual contracts by highlighting how each type works, explain funding rates and discuss some of the opportunities in trading these crypto instruments.

Perpetual Contracts

Perpetual contracts are an advanced version of futures - they allow traders to hold long or short positions for as long as they may want. These instruments have become a favorite for crypto derivative traders due their flexibility amongst other fundamental factors. They can be traded on various platforms including the Drixx crypto futures exchange which offers exposure to Bitcoin and Ether through respective perpetual contracts.

When trading perpetual contracts, buyers and sellers have the option to execute a trade at their preferred time as opposed to the expiry dates set in forward and futures contracts. This flexibility has proven to be a game-changer for perpetual contracts - a good part of crypto derivative traders now use these instruments on a daily basis. So, how do they work exactly? Let’s find out in the next section which features normal and inverse perpetual contracts.

Normal Perpetual

True to its name, a normal crypto perpetual contract is structured in a simple way. These contracts have crypto assets like BTC as the underlying asset while their value is calculated based on a price index - it could be the average or median price of BTC according to various exchanges. Normal perpetual contracts are quoted in crypto (BTC, ETH) while the payout is made in fiat currencies such as the USD or EUR.

For practicality, let’s take the example of a trader who wants to buy a BTC perpetual contract worth 100 units. If each unit represents 10 BTC, the trader will open a position whose quantity is equivalent to 1,000 BTC. This means that if the price of Bitcoin goes up by 30%, the trader’s position will be in profit, and the quantity will still be quoted in BTC. However, the pay out to this position will be made in fiat currency. As for the settlement dynamics, buyers(holders of long position) normally pay the sellers(holders of short position) or vice versa depending on the funding rate - the technicality of this arrangement is explained in a later section of the article.

Inverse Perpetual

Popularly known as the ‘inverse perp’, this type of crypto derivative contract is the opposite version of a normal perpetual - the quantity is quoted in fiat currency while payout is made in crypto. Inverse perpetual contracts have gained traction in the crypto market because of their convenience and ease of stacking crypto from trading activities. They are now a common way to avoid dealing with fiat currencies or stablecoins.

To get a better picture, let’s take the example of another trader who wants to buy a BTC inverse perpetual contract. If they buy 5,000 units, it means that the quantity of their position is equivalent to $5,000 dollars. Should the price of BTC move up by 20%, they will have made $1,000 - however, the payout will be in BTC as opposed to USD. You can also read more about inverse perpetuals in an in-depth technical article on the Drixx academy blog.

Funding Rate

Unlike forwards and futures, perpetuals have no expiry dates - they are settled on a daily basis or within shorter time frames depending on the funding rate. This type of settlement ensures that the price of a perpetual converges towards the price of the underlying crypto asset at any time, hence sustaining and even improving market efficiency.

Funding rates payments are made periodically by either the longs or shorts in a given perpetual position. There are two types of funding - positive and negative.

Positive funding occurs when the perpetual is trading at a price higher than that of the underlying crypto asset, while negative funding occurs when the contract is trading at a lower price. In the first scenario, traders who have long positions pay those on the short side and vice versa in the latter case.

Different crypto derivative exchanges have their own way of calculating the funding rate - this normally informed by the premium and interest rate being offered. At Drixx, we calculate the funding after every 8 hours while the settlements are made 8 hours later. You might also want to check out the full calculation details of the BTC-perp contract as offered on Drixx.

Insurance fund

Trading crypto derivatives is highly risky and requires some form of backup to ensure that the winning party gets their settlements. This is where an insurance fund comes in - crypto derivative exchanges use this mechanism as a way of protecting themselves and the winner, if the liquidated counterparty’s account goes to a negative balance. In such a case, the insurance fund is used to cover for the losses to avoid auto-deleveraging (ADL) which means an algorithmic liquidation of the losing counterparty (can be based on factors such as leverage size or unrealized profit).

Pros and Cons of Trading Crypto Perpetuals

Trading crypto perpetuals has some pros and cons, let’s start with listing the pros:

Flexibility

Perpetual contracts are more flexible than forwards and futures which are limited by expiry dates. You can open or close a crypto-perp position at any time you want. This also provides flexibility to change from a long to short position or vice versa with ease.

Leverage

Unlike spot trading, derivatives offer traders an opportunity to open leveraged positions. This means that their initial capital is amplified by a factor like 10X or 100X depending on the asset and risk appetite of the trader. On Drixx, the leverage on BTC-perp can go as high as 100X - meaning that a trader with an initial capital of $100 can leverage their position to trade with up to $10,000.

Exposure

Crypto perpetuals provide exposure to assets like Bitcoin and Ether without requiring a trader to necessarily buy these assets. In simpler terms, the value of a crypto-perp is derived from an underlying asset, which could be BTC or other crypto assets. Such indirect exposure makes it easier to trade in the crypto market, with the flexibility of going long or short on any supported asset without the need of actually owning it.

Cons

While crypto perpetuals offer multiple opportunities for traders to optimize the crypto market, they also come with some cons:

Risky

Trading crypto perpetuals can be highly risky, given the large exposure to leverage and general volatility of the cryptocurrency market. In some instances, traders get liquidated as soon as they enter a position, especially when high leverage is used, without the proper understanding of the contract mechanism and as a result of general lack of trading experience. This can go to the extent of account bankruptcy (account balance goes to zero).

Technicality

The operations involved in trading crypto perpetuals can be quite technical especially for a newbie trader. It may take some time before you get a hinge of how these instruments work, therefore it is highly recommended to do demo trading and experiment with smaller amounts until substantial positive experience is accumulated. This is not the case with spot trading where buying or selling a particular crypto asset is almost as easy as shopping for a digital product on amazon or ebay.

Margin re-calculation

When opening a crypto-perp position, there are some margin requirements which need to be maintained at all times to avoid liquidation - one of them is the maintenance margin requirement. This metric is calculated based on some factors such as the price of the underlying asset. A trader can enter a position with a certain maintenance margin and be later required to top in order to avoid liquidation, if it happens to be re-calculated due to price shifts,

Conclusion

Crypto perpetuals are likely to gain even more traction in the near future as the market continues to attract capital from veteran and new traders. These derivative instruments have proven to be a core part of the crypto market structure and might as well shape its future. Currently, they are being used in crypto portfolio management to introduce strategies such as hedging and risk diversification. This value proposition has placed perpetuals amongst the favorite crypto market instruments - a trend that is on a constant rise ever since their introduction by Bitmex in 2016.

Disclaimer: The information presented here is for educational purposes only and should not be construed as investment advice. Cryptocurrency trading involves high risk. Drixx will always strive to do it’s best in educating customers and providing high quality products but will not be held responsible for their trading and investment decisions, losses or profits.