Perpetual contracts are very similar to futures contracts in terms of their profit and loss structures. Before we elaborate on what perpetual contracts are, let us review the basics of spot and futures trading.
Spot trading refers to the buy or sale of an asset for instant settlement.
For example, the price of crude oil is expected to rise due to the deteriorating situation in the Middle East. As such, Company A agrees with crude oil suppliers to buy 5,000 barrels of crude oil at $175,000 immediately, with a spot price of $35 per barrel. A week later, the spot price rose to $40 per barrel, which is in favor of Company A as it saves $25,000.
Futures contract is an agreement to buy or sell an asset at a predetermined price at a specific time in the future.
Ann buys a crude oil futures contract at $40 per barrel for 1,000 barrels. The futures contract will expire in December. If the price rises to $50 upon the contract expires, Ann may buy 1,000 barrels at $40 from the futures seller, i.e. physical settlement, or receive $10,000 price difference from the seller, i.e. cash settlement. Either way, Ann makes a profit of $10,000. If the price falls to $30 instead, Ann will suffer a loss of $10,000. Ann can resell the futures contract to other traders at any time before the contract expires.
Differences between Spot and Futures
1. Futures market does not exchange the underlying assets immediately, but rather settle the on a specific date in the future based on a predetermined contract.
2. The profit and loss for futures contracts can be settled either by cash or physical delivery.
Traders can enter long and short positions and leverage up via both spot and futures trading, while there are also differences.
Spot: Spot trading with leverage is in essence borrow loans. For instance, Company A is willing to pay $175,000 in principal. They are able to buy 5,000 barrels at a spot price of $35 per barrel. If the bank provides extra loan of $350,000, Company A can buy crude oil worth $525,000, which means they use 3x leverage in this trade. Company A will have to pay interests to the bank for the loan.
Futures: Ann buys 15,000 barrels of December crude oil futures at $40 each. She uses 10x leverage and thus pays $60,000 only to the futures exchange. Ann doesn’t pay any interest to the bank or the futures exchange for the leverage. However, futures price can be higher (or lower) than the spot price.
For more information on leverage, please refer to one of our earlier articles on “What is leverage?“
Long & Short
Buy/Long positions are not difficult to understand. Let’s take a look at how Ann makes profits by taking short positions on Tesla stock.
Spot: Ann borrows Tesla stocks from the securities broker and short sell at $1,000. If the price drops, Ann covers her short position at $800 and return the stock to the broker. She earns a profit of $200 per share.
Futures: Ann short December futures contract on Tesla at $1,000. If the price drops to $800 in November, she closes the position and makes profit of $200 per share too. By trading futures, Ann does not trade Tesla stocks directly or borrows any shares from brokers.
Perpetual contract trading is close to that of futures contracts. Trader can leverage up and do not exchange the underlying assets on the spot.
The most noticeable difference between perpetual and futures contracts is that perpetual contracts do not have fixed expiry and settlement time. Traders can hold a position perpetually as long as the margin is sufficient.
If Ann buys December crude oil futures at $40 per barrel, she must settle it upon contract expiry regardless of the price. If she buys perpetual contract instead, she commits to buy crude oil at $40 per barrel at a certain time in the future. However, there is no time limit on this commitment. She can exit the position and gets her margin back whenever she wants.
Without a predetermined expiry date, it’s difficult for traders to predict the settlement price and cost of funding of perpetual contract trading. Therefore, a funding mechanism is introduced. Long and short traders exchange a funding cost periodically (say every 8 hours) to reflect the price expectations during each funding interval (i.e. spread between the perpetual contract price and spot price) and the cost of funding. As such, the price of perpetual contract is anchored to the spot price.
As the price of perpetual contract is close to spot price, PnL of perpetual contract trading is close to levered spot trading. You can see the funding as a proxy of interest paid to banks, while the funding rate is more frequently adjusted than bank interest, and sometimes you even earn funding than paying it.
Essentially, perpetual contracts can be traded continuously forever. Traders don’t need to worry about any approaching expiry date or contango structure upon future roll-over. In that sense, perpetual contract trading is more flexible and more active than single futures contract in the crypto market.