A perpetual swap is a type of derivative trading product that has become increasingly popular among crypto traders over recent years, with data showing daily trading volumes of over $180 billion.
Launched on May 13, 2016, perpetual swaps offer traders a chance to take on large positions in a cryptocurrency with little money down. This opportunity to win big on small movements tends to entice a lot of people to use them, but with such big rewards come a likewise enormous amount of risk.
What are crypto derivatives?
Derivatives are financial instruments that derive their value from an underlying asset.
This is similar to futures contracts which allow investors to speculate on a cryptocurrency’s future price in the future by taking on the obligation to buy or sell an asset on a set date at a predetermined price. Options, on the other hand, give its purchaser the right – but not the obligation – to buy or sell an underlying asset at a set price at a predetermined date.
Generally, crypto derivatives offer traders a flexible method of profiting off the price movements of digital assets without exposing them to the security risks or technicalities associated with storing or holding cryptocurrencies.
As a trader interested in betting on the price of crypto assets, you could either purchase an asset at an exchange or trade a derivative product anchored to the value of the digital asset. In the former, the process involves holding crypto assets. In other words, when you invest in a digital asset on an exchange, you have to take the instant delivery of the specified amount of the digital asset you buy and hold them until you decide to either sell it for a profit or loss. This is also known as spot trading.
In contrast, trading crypto derivatives do not come with any custody requirements for the investor. Instead of holding the asset directly, derivatives traders simply buy and sell digital contracts.
What are futures contracts?
As its name implies, a futures contract is basically a financial contract between two parties to sell and buy an asset at a set price in the future. In other words, future contracts allow two parties to agree on the price at which they will exchange an asset in the future. Although the duration of future contracts varies, the settlement dates of each contract are always fixed. In essence, before two parties can enter into a crypto futures contract, they must agree on closing the contract on a predefined settlement date.
For instance, the expiration of a quarterly BTC futures contract is three months from the day it is issued.
How do crypto futures contracts work?
To illustrate the core workings of futures contracts, let’s assume that the price of bitcoin is $40,000, and Alice, a crypto derivatives trader, believes that the price will be higher in a month.
She could bet on this possibility by entering into a deal that allows her to purchase 1 BTC for $40,000 a month from now. All she needs to do is open bitcoin futures contracts that collectively indicate her commitment to pay $40,000 for 1 BTC next month, regardless of the price at which the digital asset is trading on the spot market.
On the flip side of this trade is Bob, who believes the price of bitcoin will drop below $40,000 at the proposed settlement date. He is committed to selling $40,000 worth of contracts to Alice next month. In other words, Alice is “longing” bitcoin, while Bob, on the other hand, is “shorting” the digital asset.
Assuming the price of bitcoin rose to $45,000 at the expiration date of the contract, Alice would have generated a $5,000 profit since she would be purchasing BTC from Bob at a discount. In a scenario where the price of BTC dropped below the $40,000 mark at the settlement date, Alice would have to buy bitcoin from Bob at a higher price compared to the current market and subsequently incur a loss.
What are perpetual swaps?
A perpetual swap is somewhat similar to a futures contract in that it allows traders to speculate on the future price movements of cryptocurrencies. The core difference is that, unlike a typical futures contract, perpetual swaps do not have expiration dates. In essence, this eliminates the need to constantly re-establish a long or short position. For this reason, the price of perpetual contracts must be anchored to the spot prices of their underlying assets. In the case of futures, there is no need for maintaining a price peg since the value of the contract and the underlying asset automatically converge as the expiration date nears.
Due to the absence of expiration dates in perpetual swaps, exchanges implement a price anchoring system called the funding rate mechanism. This mechanism balances the short and long positions of perpetual swaps by either incentivizing or disincentivizing trades. Think of it as a rebate or fee that helps balance out the demand for the short and long side of perpetual contracts.
How do exchanges calculate funding rates?
The funding rate mechanism helps keep the prices of perpetual futures contracts at par with the market prices of the underlying assets they track. For example, if bitcoin’s current market price across a range of exchanges is $50,000, the funding rate mechanism will help make sure the perpetual swap contract price is also priced around the same $50,000 level.
Generally, exchanges use an oscillating price marker to determine whether long or short traders need to pay fees or receive rebates. When the price of a perpetual swap is above the spot price of the underlying digital assets, then we say that the funding rate is positive. In this case, traders holding long positions would pay a small fee to those shorting the digital assets.
In contrast, a perpetual swap trading below the spot price of its underlying asset has a negative funding rate. Here, those shorting perpetual swaps would pay traders holding long positions.
The exact amount paid or received depends on the size of each trader’s position. For instance, if the funding rate of a BTC/USD perpetual swap is +0.010%, a trader longing $40,000 worth of this particular perpetual swap would have to pay a fee of $4 – derived from multiplying $40,000 with 0.010%. Note that funding fees are paid at fixed intervals. On some exchanges, the funding period is set for every eight hours.
How do perpetual swaps work?
Traders can long bitcoin by purchasing perpetual swaps and selling them some time in the future for profits. For example, Alice buys 2 BTC/USD perpetual swaps by depositing $80,000 as collateral. As such, each BTC/USD perpetual swap is worth $40,000. Assuming the price of bitcoin rises steadily to $50,000 the following month, and Alice decides to close her position, she would have generated a $10,000 profit on each perpetual swap purchased. Her total profit would be roughly $20,000.
profit = number of perpetual swaps * (current price - entry price)
profit = 2 * ($50,000 - $40,000)
profit = $20,000
It is worth noting that this calculation does not take into account the effect of funding rates on the profitability of Alice. The fees paid and the rebate received by Alice as part of the exchange’s attempt to peg the perpetual swap to bitcoin’s spot price would determine the exact figure that Alice generates.
Also, Alice could take advantage of the leverage opportunities available to perpetual swap traders to multiply profits. To do this, she could purchase perpetual contracts worth double the amount she initially deposited as collateral. With this strategy, the size of her position would be $160,000 (or 4 BTC/USD perpetual swaps), even though her collateral is half of the value of perpetual swaps she is trading. In such a scenario, Alice has taken advantage of a 2x leverage. Assuming she closes her position when each BTC/USD perpetual swap is selling for $50,000, her profit will be roughly $40,000.
profit = 4 * ($50,000 - $40,000)
profit = $40,000
Interestingly, some exchanges allow traders to access up to 125x 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 swaps falls by 50% from the initial price she bought them.
profit = 4 * ($20,000 - $40,000)
loss = $80,000
When a trader’s unrealized loss equals the collateral deposited, exchanges automatically close the trader’s position. As such, the entirety of the collateral would be lost. Therefore, the risk that comes with using margins or trading with leverage is significant and should NOT be attempted by novice traders.
In summary, while trading perpetual swaps contracts is highly risky they are appealing because they allow traders to speculate on the short-term or long-term price movements of digital assets without time constraints. The possibility of generating profits even when the prices of cryptocurrencies fall is also one of the added advantages of perpetual swaps.
Nevertheless, it’s advised traders should always perform their own due diligence and seek professional advice from a financial advisor before making any investment in cryptocurrency. When trading perpetual swap contracts, it’s possible a trader may lose their entire invested capital – especially when leverage is used.
Correction (10/08/21): Previously stated perpetual swaps were inherently non-custodial. This was not true and has now been removed.
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