Perpetual Contracts: Rates, Arbitrage, & Exchanges

According to Bloomberg, 93% of all BTC Futures being traded in May 2022 were perpetual contracts. Launched by the BitMEX crypto exchange in 2016, perpetual contracts allow traders to take on large positions with the aim of generating income by small price movements from its underlying cryptocurrencies.

This has made perpertuals increasingly popular in the trader community, with trading volumes often in billions of dollars.

In this article, we’ll go through what perpetual contracts are, where you can use them, and their pros and cons.

What Are Perpetual Contracts?

A perpetual contract is a crypto futures contract without an expiry date. Like a futures contract, a perpetual contract is a derivative that derives its value from the underlying crypto asset.

Buy & Sell

You can buy or sell the underlying crypto asset at a pre-agreed price but close it whenever you deem fit. The pre-agreed settlement price is the price of the crypto asset at the time of opening the contract.

How Perpetual Contracts Work

A perpetual contract enables traders to speculate on the underlying cryptocurrency’s future price movements. Let’s understand this with an example.

Assume BTC is currently trading at a spot rate of $30k, and you expect it to reach $40k within one month.

So, you buy/open a futures contract of 1 BTC at $30k with an expiry of one month.

But suppose BTC is trading at a spot rate of $38k after 20 days. You believe it’s a good opportunity to register an $8k profit and don’t want to wait until it hits $40k.

You can settle this order in two ways:

• Closing the same open futures contract by selling it at $38k.
• Setting up a fresh sell futures contract at $38k. This will cancel out your already open buy futures contract, which you had purchased for $30k.

In both cases, you’ll profit around $8k.

If you don’t close your futures contract before its expiry, the platform will automatically settle it upon expiry at the market rate.

The perpetual futures contracts work almost the same as above, except for a few modifications.

As a perpetual contract doesn’t expire, you’ll need to close it manually or set up a reverse trade for its automatic closure at a specific price point.

The exchange may also liquidate your position automatically if your leverage maintenance margin falls below the required threshold.

What Are Perpetual Funding Rates?

Since perpetual contracts don’t expire, their value can differ from the spot rate. In a bull market, a 1 BTC perpetual contract could trade at $30.1k, even if BTC is trading at $30k in the spot market.

Therefore, to avoid their loss, exchanges implement a price anchoring mechanism called BTC funding rates. This is done to keep their price closer to the spot rate.

If the price of the BTC perp is higher than the BTC spot rate, the buyers of the perps (called longs) will need to pay a funding fee to the sellers (called shorts).

This encourages more sellers to enter the market and bring down the BTC perpetual’s price closer to the market rate. The vice versa happens when the perpetual contracts are trading below the underlying asset’s market rate.

Please note that the funding fee you pay or receive will depend significantly on the size of your open positions and the underlying crypto asset.

Hence, if you open highly leveraged long positions, you may pay a substantial funding fee to the shorts.

Example Of A Perpetual Contract

Let’s use the earlier example to understand the funding fee better. You place a market order to buy a perpetual futures contract of 1 BTC at $30k, and it’s filled up by a seller almost instantly. In this case, you’re long on BTC, and the seller is short on it.

Assuming that the current funding rate is 0.01% and is paid out every 8 hours, you’ll need to pay the seller a funding fee = 0.01% x your position value for your open contract at the next payout interval.

If, after 20 days, the BTC spot rate has increased to $38k, you can close your contract. However, you’ll need to continue paying the funding fee to the seller for those 20 days (if the funding rate stays positive).

As this contract has no expiry date, you can also keep it open and close it when you want.

Why Use Perpetual Contracts?

• Perpetual contracts allow users to hold on to their leveraged positions for longer durations without expiring. This gives them the flexibility to exit their trades at the right time.
• Many crypto traders use perpetual contracts to earn passive income through funding fees. They open leveraged short positions in the perpetual futures market and then open equally-sized long positions in the spot market to offset their risk.

Where To Trade Perpetual Contracts

• Bybit:Best for range of USDT and USDC-backed perpetuals
• dYdX: Best for DeFi

1. Bybit

Launched in 2018, Bybit has become the preferred derivatives exchange for over 2 million crypto traders.

Trading Perpetuals On Bybit

You get to pick from a wide range of USDT, USDC, or crypto-backed perpetual contracts, including BTC, ETH, ETC, SOL, and BNB.

The offered leverage can go up to 100x. The funding fee is paid every 8 hours at 00:00 UTC, 08:00 UTC, and 16:00 UTC. It’s calculated based on the following formula:

Funding Fee = Position Value x Funding Rate

Position Value = Quantity of Contract / Mark Price.

The calculation of Funding Rate is as follows:

Funding Rate (F) =Premium Index (P) +clamp (Interest Rate (I) –Premium Index (P), 0.05%, -0.05%)

3. dYdX

dYdX is a US-based decentralized crypto derivatives exchange that delivers the efficiency and features similar to a centralized trading platform.

Trading Perpetuals On dYdX

The dYdX exchange uses Starkware’s StarkEX layer 2 scaling solution to allow crypto perpetuals trading in a non-custodial and trustless environment.

The platform features 30+ crypto perpetual markets, and you’re allowed up to 20x leverage to tradeperpetuals on margin.

The funding fee is paid out in USDC hourly, and the funding rate changes every 8 hours. Here’s how it’s calculated:

Funding Fee =Size of the Position (S) xIndex price for the market supplied by Oracle (P) xFunding Rate (R)

Funding Rate =(Premium Component / 8) +Interest Rate Component

How People Make Money Off Perpetual Contracts

People make money through perpetual contracts by speculating on crypto price movements without dealing with the complexity of sending/receiving actual crypto assets.

Combined with leverage, skilled traders can make potentially larger profits with perpetuals, though losses are equally magnified.

Arbitraging is another commonly used method to make money from perpetual contracts. Here’s how it works:

Arbitrage

Due to inefficiencies of the crypto market, there are typically differences between a crypto asset’s spot price and perpetual contract price on different exchanges. This offers an arbitrage opportunity to traders.

Here are two commonly used arbitrage methods:

• The first method uses the convergence of basis. Let’s assume that BTC perpetual is selling for $31k on Exchange A and the BTC spot price on Exchange B is $30k. You can buy 1 BTC in the spot market and then sell it in the perpetual. You can liquidate your position in both markets as the prices converge. If the convergence point is $28k, selling 1 BTC in spot will incur a loss of $2k; however, closing your perpetual contract at that price will earn $3k. Your overall profit will be $1k.
• The second method is based on the funding fee. Let’s assume the funding fee for BTC perpetuals is +0.1% on Exchange A. This means that longs will pay shorts 0.1% in every payout interval. Let’s also assume that the BTC spot and contract price are identical on both Exchanges A and B. You can buy $20k worth of BTC in Exchange B’s spot market and sell a $20k BTC perpetual contract on Exchange A. This will earn you a funding fee on Exchange A, while offsetting/hedging any losses through the spot trade on Exchange B. You’ll continue earning this yield if the funding rate stays positive.

Pros And Cons Of Perpetual Contracts

Pros and Cons Explained

Pros

No Expiration

Perpetual contracts offer the flexibility of closing one’s position at the most profitable time. You can set up multiple contracts to better manage your risks without constantly keeping track of every contract’s expiry.

Different Hedging Possibilities

Perpetual contracts allow traders to use different hedging possibilities to offset their losses in the spot market. Traders can even benefit from the funding fee and earn passive yield.

Profit Potential Even In Stable Markets

As perpetual contracts can be set up with leverage, you stand to make significant gains. If you trade with 100x leverage, even a small price change can lead to significant gains. However, the losses are also equally bigger.

Cons

Funding Rate Costs

Apart from the risk of volatile price movements, traders must also pay a premium on their open long positions. The same holds true for shorts in a bear market.

Amplified Losses If Using Leverage

Anyone who uses leverage for their perpetual trades must deposit a certain amount of initial and maintenance margin. This investment can get wiped out (liquidated) quickly if you take significantly large positions.

Not Ideal For Beginners

Learning perpetual contracts can be particularly steep for someone starting in the crypto trading industry and even for people new to futures. Rushing into perpetual contracts trading without enough knowledge and experience can lead to major losses.

Final Thoughts On Perpetual Contracts

Perpetual contracts are a cleverly-designed derivative variant that has become quite popular. A perpetual contract offers the best of both futures and spot markets, allowing traders to use leverage without worrying about expiring futures contracts.

However, as with any leveraged trade, perpetual contracts have the inherent risk of losing one’s entire initial investment. This risk is higher if you take on significant leverage. Therefore, you must do your due diligence and understand the risks before trading perpetuals.