Understanding Futures Trading in Cryptocurrency

According to CryptoQuant, nearly $80 billion in positions on centralized exchanges were liquidated in 2021, averaging more than $200 million per day.

 

Key Takeaways

  • The most common futures contracts in cryptocurrency exchanges are perpetual swaps.

  • Leverage is expressed as a ratio, such as 1:5 (5x), 1:10 (10x), or 1:20. (20x). It indicates how much your initial capital has been multiplied.

  • When the funding rate is greater than zero (positive), long traders (contract buyers) must pay short traders (contract sellers).

  • A negative funding rate, on the other hand, means that short positions pay longs.

Understanding Futures Trading in Cryptocurrency

Introduction

Futures, a derivative financial contract, obligate parties to buy or sell an underlying asset at a predetermined price and specified future date. It was first established to trade rice futures in 1730 in Japan by the Dojima Rice Exchange.


When the contract expires, the holder of a futures contract must buy the underlying asset, and the seller must sell the underlying asset at the predetermined price regardless of the current price.


What is a Perpetual Swap Contract

A perpetual contract, also known as a perpetual swap, is a type of futures contract without an expiry date. Meaning that one can hold a position for as long as they like without the need to roll over contracts. It is the most common futures contract in cryptocurrency exchanges.


Perpetual contracts trading is based on an underlying Index Price, the average price of an asset across the major spot markets, and their relative trading volume. Unlike conventional futures, perpetual contracts tend to trade at a price that is the same or close to the spot markets. However, the mark price might deviate from the spot market price during extreme market conditions.


Perpetual Swap Terms

There are several key perpetual swap terms to understand. Let's look at what each of these terms means in the crypto trading derivative markets.


Leverage - Increases your purchasing or selling power, allowing you to trade with more capital than you currently have in your wallet. Leverage is expressed as a ratio, such as 1:5 (5x), 1:10 (10x), or 1:20. (20x). It indicates how much your initial capital has been multiplied.


Funding Rate - Regular payments made by buyers and sellers based on the current funding rate. When the funding rate is greater than zero (positive), long traders (contract buyers) must pay short traders (contract sellers). A negative funding rate, on the other hand, means that short positions pay longs.


Mark Price - An estimate of a futures contract's fair value price. It aids in preventing unfair liquidations that can occur due to price manipulation or when the crypto market becomes volatile. The mark price is usually determined by the index price and the funding rate.


Insurance Fund - helps prevent balances from dropping below zero and ensures that traders get any profits owed to them. If liquidations do not happen properly, the insurance fund backstops those losses until the positions are closed. All fees from liquidation go into the insurance fund.


Profit & Loss (PnL) - There are two types of PNL, unrealized and realized, depending on a trader’s open and closed positions. Unrealized means that the trader hasn't closed the position, while realized means that the trader closed the position.


Perpetual Swap Margin Requirements

There are two types of margin requirements: initial margin and maintenance margin.


Initial Margin - the minimum amount required to open a leveraged position and serves as collateral for your leveraged position. For example, you need an initial margin of 1 ETH to buy 10 ETH at 10x leverage.


Maintenance margin - the bare minimum of collateral required to keep open trading positions. If your margin balance falls below this level, you will be liquidated. For example, you market open a 10 ETH position at 10x leverage, and the price of ETH falls by 9%. Your position would be at a loss of 0.9 ETH, which is almost your entire initial margin, and you will be at risk of liquidation if you do not have additional collateral to keep the position open.


The distinction between the two is that the initial margin is the amount you commit when opening a position, whereas the maintenance margin is the minimum balance required to keep the positions open. The maintenance margin is a dynamic value that varies with market price and account balance (collateral).


Pros and Cons of Perpetual Swaps

Pros and Cons of Perpetual Swaps

Pros of Perpetual Swaps

Small Starting Capital

Some of the crypto exchanges’ perpetual swap allows you to leverage up to 100x (1:100), which means that with just a starting capital of 1 BTC, you can open a position of 100 BTC. This allows you to profit more with lesser upfront costs.


High Liquidity

Being the most traded product in crypto exchanges, perpetual swap markets have high liquidity profiles, making it easier for traders to participate.


Cons of Perpetual Swaps

Funding Rate Costs

Even though you could earn from receiving funding rate payments, the funding rates are always against the trend. You are more likely to find yourself going with the trend and against the funding rates.


Amplified Loss

Leveraging is a double-edged sword. It allows traders to profit more, but at the same time, it amplifies the loss. When you leverage x100, a 1% price movement against your position (Long/Short) is equivalent to a 100% loss.


Liquidation Risk

The crypto market is very volatile, with thousands of traders getting liquidated daily. Compared to the traditional spot market, your crypto might be liquidated to cover any of your leverage loss.


Should you try Crypto Perpetual Swaps

Using leverage significantly increases the risk, and it is the responsibility of the investors to manage their own risk. If you can manage your risk well and have knowledge of trading, you can make use of the leverage to increase the number of positions and diversify your portfolio.