What Is a Perpetual Futures Contract?

What is a perpetual futures contract? To understand it, you first need to understand futures contracts. In this post, I'll explain the difference between futures contracts and perpetual futures contracts, along with the key points you need to know, as simply and thoroughly as possible.

What Is a Futures Contract?

A futures contract is a contract to buy or sell a commodity, currency, or other product at a predetermined price at a specific point in the future. The key point here is that you are buying and selling a contract.

In the futures market, participants cannot directly buy or sell commodities or digital assets. Instead, they trade contracts that represent them, and the actual asset (or cash) is exchanged when the contract is exercised in the future.

Also, unlike the spot market, trades in the futures market are not "settled" immediately. Instead, the two counterparties agree on a future date on which the contract will be settled.

This might be a little hard to grasp, so let's look at an example. Think of a futures contract on a physical commodity like gold. Traditional futures markets offer a futures contract called a "Gold Futures Contract (Physical Delivery)." The two parties involved don't buy and sell gold directly. Instead, they trade a contract to buy and sell it, and on the delivery date, they actually exchange the gold for cash. Makes a bit more sense now, right?

One more thing worth knowing: in today's futures markets, most contracts use cash settlement rather than physical delivery. In other words, cash is exchanged on the expiration date without any physical exchange of the commodity.

Why Trade Futures Contracts?

So why would anyone trade futures contracts, which are contracts for the future, instead of trading the commodity directly? There are three main reasons.

1. Hedging and risk management: With futures contracts, you can open a short position to protect against a drop in the value of your assets.
2. Short selling: With futures contracts, you can enter a short position even if you don't hold the actual asset.
3. Leverage: With futures contracts, you can open a position larger than the value of your account balance.

What Is a Perpetual Futures Contract?

Now that we've covered futures contracts, shall we move on to perpetual futures contracts? A perpetual contract is a special type of futures contract. Unlike traditional futures contracts, it has no expiration date. In other words, the contract never expires and continues indefinitely.

That might sound strange at first, but remember how I mentioned that most contracts today use cash settlement, with no physical exchange of goods? Once you understand that concept, perpetual futures are easy to grasp. Simply put, a perpetual futures contract is a traditional cash-settled futures contract without a set settlement date. So market participants can buy and sell contracts with each other whenever they want.

To sum up, a perpetual futures contract is a product that lets you hold a position for as long as you like with no expiration, and settle that contract position in cash with your counterparty at any time you choose.

By now, you should have a good understanding of perpetual futures contracts. While we're at it, let's take a little more time to go over a few key points that matter in futures trading. Keep reading.

The Concepts of Leverage and Margin

In futures trading, you can use leverage to open a position worth more than the assets you hold. What you need for this is margin (collateral).

For example, let's say you open a position to buy 1,000 BNB with 10x leverage and an initial margin of KRW 1 billion. In this case, the amount actually used is not KRW 1 billion but KRW 100 million. In other words, you can buy a position worth KRW 1 billion using KRW 100 million as margin collateral.

• Leverage: A tool that lets you open a position worth more than the assets (cash) you hold (1x to 100x)
• Margin: The collateral required to use that leverage

Do you understand the concepts of leverage and margin? But there's a problem. What happens if the value of the position falls below the value you bought it at? In other words, what if you open a long BNB position and the price of BNB goes down instead? That's when a forced liquidation of your position can happen.

What Is Forced Liquidation?

Forced liquidation is the process by which your futures account is liquidated when your margin balance falls below the required maintenance margin. Liquidation works differently depending on the exchange you use. In general, the liquidation price depends on each user's risk and leverage (based on margin and net exposure).

In theory, if you open an isolated long position with 10x leverage, your position will be forcibly liquidated if the price drops by close to 10%.

To avoid liquidation, you can close your position before it reaches the liquidation price, or add more funds to your margin balance to give yourself more room before the liquidation price. The best approach is to actively use risk management tools such as a stop loss before your position is at risk of liquidation.

What Is the Funding Rate?

The last concept we'll cover is the funding rate. The funding rate is a bit complex, but it's a key concept in perpetual futures contracts that adjusts the premium in the futures market through market mechanisms.

Futures contracts are basically derivatives that track the movement of an underlying spot asset, right? With traditional futures contracts, even if a price gap opens up between spot and futures, the futures price naturally converges toward the spot price around the delivery date. But since perpetual contracts never expire, a mechanism is needed to narrow the price gap between spot and futures.

For example, when a perpetual futures contract trades at a higher premium than the spot market, long positions are required to pay a funding fee to short positions. In this situation, long positions will decrease and short positions will increase, so you can expect the futures price to fall and move closer to the spot price.

That's what the funding rate means and how it works. To sum up, the funding rate was introduced to adjust the gap between the spot price and the futures price. When the funding rate is above 0 (positive), traders in long positions (contract buyers) must pay a funding fee to traders in short positions (contract sellers). Conversely, when the funding rate is negative, short positions pay a funding fee to long positions.

Wrapping Up

That covers the difference between futures contracts and perpetual contracts. We also went over the key concepts you need to know for perpetual futures contracts: leverage, margin, and the funding rate. Futures contracts can be risky, but when used well for the right purpose, they can be a great way to protect the value of your assets and earn profits in a bear market.