Just about every asset class you can invest in or trade has derivatives. Derivatives allow you to speculate on the price of an asset without necessarily owning the underlying asset.
Cryptocurrencies are similar. There are derivatives called perpetual contracts that allow you to speculate on the price of cryptocurrencies without crypto assets actually changing hands. And some speculators like the idea of perpetual contracts because they offer a way to earn a funding fee, providing some income as long as the contract is open.
Let’s take a look at perpetual contracts and how they work.
What Are Perpetual Contracts?
As the name implies, perpetual contracts (sometimes called perps) are derivatives that don’t have an expiration date. It operates similarly to a more traditional futures contract on more conventional asset classes.
The difference, though, is that a “regular” futures contract has an expiration date. Perpetual contracts don’t have expiration dates. As long as you can maintain the required margin, you can keep the contract open indefinitely.
Because there is no expiration date and no settlement requirement, the person who buys a perpetual contract doesn’t have to worry about receiving a transfer of cryptocurrency at some point, nor do they have to worry about rolling over the contract upon expiration.
It’s important to note that perpetual contracts use leverage. This means that you control a larger notional position than you actually have money for. This can help you magnify your gains, but it also has the potential to increase your losses as well.
How Perpetual Contracts Work
With a perpetual contract, your position’s value is impacted by changes in the price of the underlying asset. Some of the most popular perpetual contracts are based on Bitcoin and Ethereum. They have standard sizes, and the notional value position you control depends on how many contracts you buy.
For example, a Bitcoin (BTC) perpetual contract is worth a standard $1. So, if you purchase a Bitcoin perpetual contract, you agree to pay $1 worth of BTC. Conversely, if you sell a Bitcoin perpetual contract, you agree to receive $1 worth of BTC at the price agreed on.
Usually, the price is set by an index or weighted look at how different exchanges price BTC relative to the dollar. So if the price of BTC is $26,000, the amount of BTC agreed to is 0.00003846. Contract values fluctuate along with the price of the underlying asset. The contract might be “worth” more or less depending on the spot rate of BTC.
In general, though, these perpetual contracts aren’t actually about receiving or transferring BTC. When you buy the contract, you buy the contract, not the underlying asset. You speculate whether the price will rise (long) or fall (short).
Perpetual Contract Funding Rates
The key to perpetual contracts is the funding rate. The value of a perpetual contract depends on what’s happening with the underlying asset. Funding rates are often taken care of every eight hours, and it’s a way of trying to keep the price of a perpetual contract in line with the spot price of the underlying asset.
For example, if the BTC perp is higher than the spot rate for BTC, those who are long on the contract (buyers) end up paying a small funding fee to those who are short on the contract (sellers).
Conversely, if the perpetual contract is trading at a lower rate than the spot price of the underlying cryptocurrency, then the shorts end up paying a funding fee to the longs.
One of the reasons that some people like using perpetual contracts is due to the potential to be on the receiving end of the funding rates. If you’re long on a BTC perpetual contract, and the underlying keeps rising—and the value of BTC perps keeps rising—you’ll be able to sell your contract for a higher price than you bought it for, but your total profit will be impacted by the funding fee you pay while the contract is in force.
Leverage & Perpetual Contracts
Perpetual contracts are usually highly leveraged. For example, you might be able to control a larger position for a smaller amount of U.S.-denominated capital. Let’s say that you’re able to buy a contract of 1 BTC at $26,000. You’re not actually going to pay $26,000 for the contract as you would to get a single BTC on an exchange.
Instead, you might use a much smaller amount. For example, you might be able to control a position up to 100x the capital you put in. So, you might be able to use $260 to control a position worth $26,000. If the price of BTC rises and you maintain your contract, though, you’ll have to pay a fee to those who are short due to funding rates.
Perhaps the funding rate is 0.01%. You’ll pay that funding rate every eight hours based on the price of the underlying crypto asset and your open position. In this case, you’d be looking at paying $2.60 each time. However, as the price rises, your funding fee will go up. If you hold the position for a longer period of time and the price of BTC continues to rise, you’ll end up paying a higher funding fee.
Eventually, you decide to sell the contract. Maybe by the time you sell the contract, its value will be $32,000. That’s a $6,000 profit minus the various fees paid, including potential entry and exit fees, funding fees and any margin fees you might have paid.
The leverage involved can help you potentially realize a bigger profit compared to the amount of capital you put in to control the position. However, while leverage can result in higher profits, it can also mean bigger losses.
For example, if you bought the $26,000 contract and the price drops, if you sell the contract, you’ll lock in bigger losses. Although, as someone who is long, and with the price dropping, you’ll receive funding fees as long as the price is down.
As long as your account has its maintenance margin, you’ll be able to keep the position open in the hopes that eventually the price will rise again.
This is the amount you’re expected to keep in your account in order to maintain your leveraged position. Your margin will depend on the exchange’s rules. For example, you might be required to maintain 3% in your account, denominated in BTC, for a contract. If your position is $26,000, you might need to have $780 worth of BTC (about 0.03 BTC) in your account.
If your account value falls below the required maintenance margin, you’re required to add more to the account. If you don’t deposit, you might see that some of your other positions could be liquidated to cover the account. Another possibility is a margin call, in which the amount you borrowed is called due immediately.
When trading anything—including crypto derivatives—using leverage, you need to understand margins and margin maintenance.
Pros & Cons Of Perpetual Contracts
As a trader, there are some advantages and disadvantages associated with trading cryptocurrency perpetual contracts.
Are Perpetual Contracts Safe?
Before deciding to trade perpetual contracts, you should carefully consider whether you can afford the potential losses, and understand how leverage can magnify your losses. It’s also important to have an idea of how fees can cut into overall profits. Calculate breakeven points, figure out how much profit you want to reach to lock in gains, and consider setting stop losses when necessary.
It’s also important to understand that you’ll need to exit your position when you’re ready.
Traditional futures contracts usually have a set expiration, at which point the position is automatically closed. This doesn’t happen with a perpetual contract. When you’re ready to close, you’ll need to take the initiative.
The Bottom Line
Before trading perpetual contracts, understand how they work. It can be a good idea to get a handle on futures contracts and other derivatives before venturing into crypto perpetual contracts.
Also, realize that each exchange has its own margin maintenance requirements and limits on leverage. Understand the funding fees and other fees as well, in order to get a feel for your true profits.
Ultimately, crypto perpetual contracts are just one of many ways you can invest in crypto. You always have to do your own due diligence and decide if an investment strategy matches your goals and risk tolerance.
Miranda Marquit, MBA, has been covering personal finance, investing and business topics for more than 15 years, and covering crypto topics for more than 10 years. She has contributed to numerous outlets, including NPR, Marketwatch, U.S. News & World Report and HuffPost. She is an avid podcaster, co-hosting the podcast at Money Talks News. Miranda lives in Idaho, where she enjoys spending time with her son playing board games, travel and the outdoors.