Perpetual Swaps: Everything to Know

Overview

Cryptocurrency perpetual swaps are derivative contracts that track the price of an underlying asset, allowing traders to speculate on its value without owning it. These swaps are a type of derivative contract that allows traders to take positions on the future price of a cryptocurrency without an expiration date.

Unlike traditional futures contracts that have fixed settlement dates, perpetual swaps are designed to mimic the spot market, providing continuous exposure to the underlying asset. This means that traders can hold their positions indefinitely, as long as they meet the required margin requirements.

A Brief History

The concept of perpetual swaps was first introduced by BitMEX, a prominent cryptocurrency exchange, in 2016. BitMEX's perpetual swap contract for bitcoin quickly gained popularity due to its unique design and the absence of an expiration date. This innovative approach allowed traders to enter leveraged positions on bitcoin's price without the need for rolling over contracts or worrying about settlement dates.

The success of BitMEX's perpetual swaps paved the way for other cryptocurrency exchanges to introduce similar products. Today, major exchanges like Binance, Huobi and OKEx offer perpetual swaps for a wide range of cryptocurrencies, expanding the availability of this trading instrument to a larger audience.

Perpetual Swaps: Everything to Know

• Mechanics of Perpetual Swaps - Perpetual swaps are typically structured as contracts between two parties: The long position holder and the short position holder. The long position holder benefits from an increase in the price of the underlying cryptocurrency, while the short position holder profits from a decrease in price. The contract is settled periodically to ensure that the price of the perpetual swap closely tracks the spot price of the underlying cryptocurrency.

To achieve this price tracking, perpetual swaps incorporate a funding mechanism. Funding occurs at regular intervals, usually every 8 hours, and is exchanged between the long and short position holders. If the perpetual swap's price is higher than the spot price, the longs pay the shorts. Conversely, if the perpetual swap's price is lower, the shorts pay the longs. This mechanism helps keep the perpetual swap's price in line with the spot market.

• Leverage and Margin - One of the key features of perpetual swaps is the ability to trade with leverage. Leverage allows traders to amplify their exposure to the underlying asset, potentially magnifying profits or losses. For example, a trader with 10x leverage can control a position that is ten times larger than their initial investment. However, it is important to note that leverage also increases the risk of liquidation if the market moves against the trader's position.

To enter a perpetual swap trade, traders are required to maintain a certain level of margin in their trading accounts. Margin represents a portion of the total value of the position and serves as collateral for the trade. The required margin varies depending on the leverage chosen and the specific platform's rules. Traders must closely monitor their margin levels to avoid liquidation, which occurs when the account's margin falls below the required threshold.

• Funding Rate and Premiums - As mentioned earlier, perpetual swaps employ a funding mechanism to maintain price alignment with the spot market. The funding rate is a crucial component of this mechanism. It is the periodic fee paid by one side of the contract to the other to ensure the perpetual swap's price remains in line with the spot price. The funding rate is influenced by the difference between the perpetual swap's price and the spot price, as well as market demand.

In times of high demand for long positions, the funding rate may turn positive, with longs paying shorts. Conversely, when there is a surplus of short positions, the funding rate can become negative, and shorts pay longs. The funding rate is typically expressed as an annualized percentage and is applied to the notional value of the position.

Additionally, it is worth noting that perpetual swaps may sometimes exhibit premiums or discounts to the spot price. These premiums or discounts can occur due to factors such as market sentiment, supply and demand dynamics, or the overall trading activity on the platform. Traders should be aware of these premiums or discounts as they can impact the profitability of their positions.

• Trading Strategies and Risk Management - Perpetual swaps offer a wide range of trading opportunities, but they also come with inherent risks. Traders should develop robust risk management strategies to protect their capital and navigate the volatility of the cryptocurrency market. Here are a few popular trading strategies and risk management techniques employed by traders:

a. Trend Following: Traders identify and enter positions in line with the prevailing market trend, aiming to capture profits as the trend continues.

b. Mean Reversion: Traders take positions based on the assumption that the price of the perpetual swap will revert to its average or mean value after deviating significantly.

c. Stop Loss Orders: Traders use stop loss orders to automatically exit positions if the market moves against them beyond a predetermined threshold. This helps limit potential losses.

d. Take Profit Orders: Traders set take profit orders to automatically close positions and secure profits when the market reaches a specified target price.

e. Diversification: Traders diversify their portfolios by allocating their capital across multiple perpetual swaps or other trading instruments. This helps spread risk and reduce exposure to any single asset.

Getting Started

To understand perpetual swaps, it is essential to have a basic understanding of futures contracts. Futures contracts are agreements between two parties to buy or sell an asset at a predetermined price and date in the future. Unlike traditional futures contracts, perpetual swaps do not have an expiration date. This key distinction eliminates the need for traders to roll over their positions periodically, simplifying the trading process.

Perpetual swaps are typically traded on cryptocurrency exchanges that offer leverage. Leverage allows traders to amplify their exposure to the underlying asset without having to commit the full value of the trade. For instance, if a trader uses 10x leverage, they can open a position worth ten times their initial investment. This feature enables traders to potentially generate higher profits, but it also magnifies the risk of losses.

When trading perpetual swaps, traders can take either a long (buy) or short (sell) position. If a trader expects the price of the underlying asset to increase, they would enter a long position. Conversely, if they anticipate a price decrease, they would enter a short position. The profit or loss from a perpetual swap trade is determined by the difference between the entry and exit prices.

Unique Aspects

One of the key features that distinguish perpetual swaps from other derivatives is the funding mechanism. To prevent the perpetual swap price from deviating significantly from the spot price of the underlying asset, funding payments are exchanged between long and short positions at regular intervals. These funding payments ensure that the perpetual swap price remains close to the spot price, minimizing the risk of market manipulation.

The funding rate is determined by the demand for the perpetual swap contract. If the contract is trading at a premium compared to the spot price, traders holding long positions pay funding to traders holding short positions, and vice versa. The funding rate is typically calculated based on the difference between the perpetual swap price and the spot price, along with additional factors such as interest rates and market sentiment.

Another unique aspect of perpetual swaps is the use of a funding index. The funding index is calculated periodically and serves as a reference rate for determining the funding payments. It is derived from the average price of the perpetual swap contract across various cryptocurrency exchanges. By using a funding index, traders can be confident that the funding rates are fair and transparent, promoting trust and liquidity in the market.

Perpetual swaps also employ a mechanism called "auto-deleveraging" (ADL) to handle liquidations. In the event that a trader's position is forcibly liquidated due to insufficient margin, the ADL mechanism ensures that the liquidation is executed smoothly. It does this by assigning the liquidation order to the trader with the opposite position who has the highest margin. This helps to prevent market disruptions and ensures that the liquidation process is fair and efficient.