October 6, 2023
Perpetual Futures (“perps”) are the most popular crypto derivative, with more than $100 billion traded daily. The first perpetual futures exchanges offering exposure to the BTC/USD pair began trading in 2015. Perpetual futures are similar to traditional commodity or equity futures but with a few differences.
Understanding Perpetual Futures Contracts
Both types of futures represent a contract traded between buyer and seller. Traditional futures are priced based on the future market price of an underlying asset, have a specific expiration date, and can be settled physically or financially. Or, if you want to continue to hold the future, you can “roll it over” to the next contract date.
Perpetual futures have no expiration date, so they can be held in perpetuity, hence the name. They never settle, and they never have to be rolled over. However, this can, over time, enable the futures price and the underlying asset price to deviate significantly from each other. To limit this deviation, crypto futures markets use a mechanism called the "funding rate."
Perpetual Futures Funding Rate
The funding rate is a user-to-user payment designed to keep the crypto’s futures and spot prices aligned. When a future trades higher than the spot, it’s called a positive funding rate, and long positions pay a funding fee to short positions. On the other side of the equation, futures trading lower than the spot price have a negative funding rate, and short positions pay a funding fee to long positions.
The price divergence is calculated every hour, and funding credits or debits accumulate as unrealized profit/loss that settles hourly or when the net position changes. The net result is that traders are incentivized for activity that will align the contract price and spot price. Perpetual futures funding rates can significantly influence the market, affecting everything from market sentiment and profitability to liquidation risk, arbitrage opportunities, and price convergence.
Risk Management for Trading Perpetual Futures
Perp trading offers a significant advantage over spot trading: leverage. When a trader buys or sells a perpetual futures contract, they don't need to put up the full cost of the contract. They put up “initial margin,” which is the initial amount a trader must put up to open the position. The exchange on which they're trading determines this amount.
Another amount, the “maintenance margin” is the minimum amount of capital necessary to keep the contract from being liquidated. If, due to price movement, a trader’s balance falls below the maintenance margin, they must place additional funds into the account, or their position is liquidated. (For this reason, most traders try to keep an account balance that is at least somewhat above the maintenance margin amount.)
Some traders analyze liquidation data to gain valuable insights into potential short-term market moves, and serve as a leading indicator for market condition changes.
The margin you must put up depends on the specific contract and the requirements of the exchange on which the contract was purchased. Usually, this margin will be very low, meaning your leverage can be very high. For that reason, risk management is extremely important when trading perpetual futures. Some basic risk management tactics or methodologies are stop-loss orders, profit-taking rules, and systematic position sizing.
Stop-loss Orders
A stop-loss order is a preset standing order that automatically executes when the perpetual reaches a certain price. For instance: You buy a perp at $100 and determine that, if the market moves against you, you don’t want to lose more than $10. Therefore, you place a stop-loss order at $90 on that perp. If the perp increases in price, nothing happens. But if it drops to $90 (or below) the stop-loss order executes, and you’re sold out of the position.
That “below” is important to note, because in a very fast market, your order may trigger at $90 but run through the stop and execute at a price lower than $90. Nonetheless, the point is that you've limited your loss, and aren't subject to the sort of runaway loss that can destroy a portfolio.
Profit-taking Rules or Orders
These tools are the reverse of a stop-loss strategy. A profit-taking rule is simply a predetermined price or percentage gain at which point you’re going to sell. For instance, if you’re a technician trying to capture a specific chart move, and that move materializes, you take your gain and move on. Or, “If I get up 10 percent in this position, I’m cashing out.” Often, day-traders employ some kind of hard profit-taking rules. As with a stop-loss order, you can codify this in advance by placing a standing order that will stay in the market until triggered.
Systematic Position Sizing
Position sizing simply means deciding how much of your capital you want to deploy on a particular instrument or trade. For instance, many traders have simple rules, like “No single position should account for more than 10 percent of the portfolio.”
There are other ways of determining position size, such as basing it on the amount of risk that position adds to your portfolio, rather than purely the dollar value of the position. Example: You can buy a perp at $100, set a stop-loss at $90, and calculate your risk as 10 percent on that position.
The important point here is that you understand your risk tolerance, have a predetermined strategy of how you plan to manage your risk, and that you use that strategy to inform your portfolio management decisions. Having a predetermined strategy is a good idea; “winging it” is a terrible idea, especially if you’re trading perpetual futures with all the leverage they enable.
Amberdata’s Futures Data
Amberdata can help you stay on top of crypto perpetual futures with our research and commentary each month in our blogs, resource library, guides, and primers, as well as with our comprehensive, granular, and normalized data.
Amberdata provides solutions and expertise for perpetual futures as well as other derivatives, and every digital asset class. Whether you’re a financial institution just entering DeFi, a seasoned crypto-native looking to expand coverage, or a Fintech building or enhancing products, Amberdata has digital asset data solutions to meet your needs.
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