Perpetual Swap Contracts Explained
In the world of crypto derivatives trading, there are three main types of contracts: perpetual swaps, futures, and options traditional futures contracts. While these instruments help to speculate on the future price movements of an underlying asset, there are some distinct differences between them.
In this article, we will take a closer look at perpetual swap contracts, how they work, and the specifics of LBank perpetual swaps contracts.
What Are Perpetual Contracts?
Perpetual swaps represent a class of cryptocurrency derivatives that enable traders to engage in both long and short positions on an underlying asset. Similar to traditional futures contracts, they offer traders enhanced flexibility, including the utilization of leverage and the capacity to settle contracts without possessing the underlying asset.
A primary distinction between futures contracts and perpetual swaps lies in the absence of an expiration date for the latter. Futures contracts adhere to a predetermined expiration date, whereas perpetual swaps can persist indefinitely, contingent upon traders maintaining adequate margin to offset potential losses and prevent liquidation.
How Do Perpetual Contracts Work?
Perpetual contracts use a funding mechanism to ensure that the price of the contract stays in line with the underlying asset. The funding rate is calculated periodically and based on the difference between the price of the contract and the price of the underlying asset.
If the price of the contract is trading at a premium to the underlying asset, then long positions in the contract will have to pay a funding rate to short positions. Conversely, if the price of the contract is trading at a discount to the underlying asset, then short positions in the contract will have to pay a funding rate to long positions.
Key concepts of Perpetual Contracts?
Here are some key concepts that traders should be aware of in a perpetual contract:
- Expiration Date Elimination: Unlike traditional futures contracts that have fixed expiration dates (usually every few months), perpetual contracts do not have an expiration date. This feature addresses the issue that many retail investors faced with traditional futures, where they might forget the expiration date and lose their positions.
- Continuous Trading: Perpetual contracts allow traders to hold positions indefinitely as long as they wish. This continuous trading feature eliminates the need for traders to roll over their positions when the contract expires, which is a common practice in traditional futures trading.
- Funding Rate Mechanism: To ensure that the price of the perpetual contract remains close to the underlying asset’s price, a funding rate mechanism is employed. The funding rate is a fee or payment that is exchanged between long and short positions periodically (e.g., every 8 hours). This mechanism helps to prevent the perpetual contract price from deviating significantly from the actual market price of the asset.
- Market Equilibrium: The funding rate aims to keep the perpetual contract price in line with the underlying asset’s spot price. If the contract’s price is higher than the spot price, long positions pay short positions. If the contract’s price is lower, short positions pay long positions. This incentivizes traders to take actions that help bring the contract price back to its fair value.
- Interest Rate Generation: Initially, there was uncertainty about how to determine an appropriate interest rate to maintain the equilibrium. Exchanges like LBank solved this challenge by generating the funding rate endogenously based on the price difference between the perpetual contract and the underlying asset. This effectively created a self-adjusting interest rate based on market conditions.
- Price Convergence: Over time, traders and the market as a whole learned to adapt to the perpetual contract system, leading to better price convergence between the contract price and the underlying asset’s price. This has made the market more stable and mature.
- Liquidity and Trading: Perpetual contracts have become a popular way to trade cryptocurrencies and other assets, especially outside the United States. They provide traders with increased flexibility, continuous trading opportunities, and potential for profit regardless of market direction (going long or short).
Pros and Cons of perpetual contracts?
Perpetual contracts offer several advantages over traditional futures contracts. For example, they give more flexibility on how long traders can hold their positions.
They also use a funding mechanism that can help to reduce the risk of price manipulation.
Perpetual contracts have become increasingly popular among traders in the crypto market due to their flexibility and the ability to trade with leverage.
However, perpetual contracts also have some disadvantages. For example, they can be more complex than traditional futures contracts, which may make them more difficult to understand for some traders. They also tend to have higher trading fees than traditional futures contracts.
Where Do I Trade Perpetual Futures Contracts?
If you’re interested in trading perpetual futures contracts, LBank is a platform worth considering. With LBank’s mobile app, you can download and trade crypto perpetual contracts with leverage ranging from 20–25x.
Additionally, you have the option to use Tether (USDT), a stablecoin, to adjust leverage and margins after opening long or short positions.
It is important to bear in mind that the maximum leverage allowed on LBank depends on the notional value of your position. Generally, the larger the position, the lower the leverage allowed. Therefore, initial margin deposits are calculated based on the leverage selected by the trader.
Wrapping Up
Perpetual swaps represent a class of cryptocurrency derivatives that enable traders to engage in both long and short positions on an underlying asset. Traders can use leverage to amplify their potential profits and losses when trading perpetual contracts. However, it’s important to note that trading with leverage increases the risk of liquidation. Always do your research.
Disclaimer: The opinions expressed in this blog are solely those of the writer and not of this platform.
