What are Perpetual Contracts?
Since its introduction in 2016, cryptocurrency perpetual contract trading has seen tremendous growth, with data showing the total transaction volume in Q1 2021 at $14 trillion.
Perpetual contracts are derivatives that let you buy or sell the value of underlying asset with several advantages:
- there is no expiry date to your position (unlike futures).
- able to take on large positions with little money down (using leverage).
- the price of perpetual contracts closely tracks the price of the underlying asset (enabled by funding rates).
- can be used as a means to short the underlying cryptocurrencies.
Perpetual contracts provide an enticing opportunity for traders as it magnifies returns. For example, if you long BTCUSDC perpetual contracts with a 10x leverage, when the price of BTC rose by 1%, your perpetual contracts position would have risen by 10%. Some exchanges offer up to 100x leverage, meaning your $1000 long in BTCUSDC perpetual contracts would double to $2000 if BTC were to rise by a mere 1%! Hence, it is not hard to see why perpetual contract trading have seen so much growth over the years in the cryptocurrency space.
However, big rewards come with big risks. When you take on leverage in your perpetual contract trades, you face the possibility of being liquidated if the price of the underlying asset moves against your favour. For example, if you long BTCUSDC perpetual contracts with a 10x leverage, when the price of BTC falls by 10%, your perpetual contracts position would be liquidated! Therefore, proper knowledge is needed when trading perpetual contracts with high leverage.
Let’s run through an example of a perpetual contracts trade:
In July 2021, the price of a BTC is $30,000. A trader, Alice, thinks that the price of BTC will rise in the coming months and buys 2 BTCUSDC perpetual contracts by depositing $60,000 as collateral. Each BTCUSDC perpetual contract is worth $30,000. Assuming the price of bitcoin rises steadily to $40,000 the following month, and Alice decides to close her position, she would have generated a $10,000 profit on each perpetual contract purchased. Her total profit would be roughly $20,000.
profit = number of perpetual contracts * (current price — entry price)
profit = 2 * ($40,000 — $30,000)
profit = $20,000
Note that this profit calculation does not take into account funding rates. The purpose of funding rate is to keep the transaction price of perpetual contracts in line with the underlying reference price. The buyers and sellers of the contract exchange interest payment regularly, allowing the contract to mimic the margin-trading markets. We will talk more about funding rate in another post.
Besides, Alice could use leverage on her trade to magnify profits. Let’s say Alice opted to go with a 2x leverage. To do this, she purchased perpetual contracts worth double the amount she initially deposited as collateral. The size of her position would be $120,000 (or 4 BTCUSDC perpetual contracts), even though her collateral is half of the value of perpetual contracts she is trading. Assuming she closes her position when each BTCUSDC perpetual contract is selling for $40,000, her profit will be roughly $40,000.
profit = 4 * ($40,000 — $30,000)
profit = $40,000
As mentioned, some exchanges allow traders to access up to 100x leverage in order to maximize profits. However, just as leverage amplifies profits, it also amplifies losses. From our example, using a 2x leverage exposes Alice to liquidation risk if the price of the perpetual contracts falls by 50% from the initial price she bought them.
loss = 4 * ($15,000 — $30,000)
loss = $60,000
At this stage, Alice lost all her collateral and her position was closed/liquidated by the exchange.
In summary, perpetual contracts trading is enticing because traders are able to speculate on the short-term or long-term price movements of cryptocurrencies without time constraints. The ease of shorting the underlying cryptocurrencies to generate profits when their prices fall is also one of the added advantages of perpetual contracts.