What are Perpetual Swaps in Crypto? An In-Depth Guide
Perpetual swaps, a type of cryptocurrency derivative swap, recently emerged in the crypto landscape and have become increasingly popular among traders. It revolutionized the crypto space and finance at large, filling gaps left by the traditional futures market.
Imagine, for a second, having to trade futures products with expiration dates in a crypto market that operates 24/7 without any breaks. Your astonishment is just as significant as ours.
Given how popular perpetual swaps are in crypto today, it might come off as a little awkward to inquire about the fundamentals. Luckily, I will be here to walk you through it. With my 10 years of experience in the crypto landscape, you can rightfully call me an authority.
In this article, I will provide an in-depth guide, immersing you in the fascinating world of perpetual swaps.
Key Takeaways
- Perpetual swaps are a type of crypto derivative that is similar to futures but doesn’t expire. It allows short and long positions on underlying crypto assets.
- The different types of crypto derivatives include perpetual swaps, futures, options, and contracts for differences (CFDs).
- The key difference between perpetual swaps and futures contracts is that the former has no expiration date and has a funding mechanism.
What are Perpetual Swaps?
Perpetual Swaps was launched on May 13, 2016, and has had a tremendous impact on the crypto space. Perpetual swaps are a type of crypto derivative—a futures contract that never expires—that allows traders to take short (sell) or long (buy) positions on underlying assets.
While perpetual swaps are like futures, they are distinct forms of derivative contracts. Apart from the obvious fact that perpetual swaps do not expire, the key differences include the absence of the need to transfer underlying assets and low-margin requirements.
Perpetual swaps allow you to buy or sell the value of something, usually called an “underlying asset.” The distinction between actual assets and underlying are:
- Underlying assets are not actually traded.
- Their value is based on the actual asset.
- They are the foundation for derivative financial instruments.
The allure of perpetual swaps includes not having custody issues as you won’t be storing, holding, or trading the underlying asset to begin with. Perpetual swaps simply follow the price of the underlying asset while making profits from either position.
What are Crypto Derivatives?
Derivatives are securities or financial instruments whose value is based on an underlying asset. By implication, and with cryptocurrency not being a security, crypto derivatives are financial contracts or instruments that derive their value from the performance of cryptocurrencies.
Crypto trading has become a vital component of the trading industry, as have derivatives, spreading far and wide. According to CoinDesk, in a paper published on May 10, 2023, the market share of crypto derivative trading rose to $2.15 trillion.
There are several types of crypto derivatives, including future contracts, perpetual swaps, options contracts, and contracts for difference (CFDs). The options market appears to be the least popular.
Crypto derivatives offer a flexible approach to profiting off the price movement of digital assets without exposure to the risks associated with storing or holding them. The derivatives market has become increasingly popular among traders over the years, with trading volumes of over $118 billion, according to data from CoinGecko.
Perpetual Swaps in DeFi
Perpetual swaps have come a long way from XBTUSD, which was the first, according to BitMex. Perpetual swaps in decentralized finance (DeFi) function in the same way as in traditional exchanges, but with a few perks.
See below for a detailed explanation of how perpetual swaps work within DeFi:
- Smart contract-based: Smart contracts, which are self-executing, are used to create and execute perpetual swaps.
- Decentralized liquidity pools: Liquidity pools, which are needed for trading perpetual swaps, are created and funded by users.
- Leveraged trading: Leverage trading amplifies traders’ exposure to underlying assets.
- Funding rate: This is determined by the balance between long and short positions in the market.
- No expiration date: There is no fixed expiration date.
- Short or long position: You can hold a long or short position with or without leverage, which you can sell in the future. To calculate profit without leverage, you can use this formula: profit = number of perpetual swaps * (current price minus entry price). If your position is leveraged, simply multiply your profit by the leveraged percentage.
What are Perpetual Futures Contracts?
Perpetual futures contracts are financial derivatives commonly traded on crypto exchanges. It is designed to replicate futures contracts but has one significant difference—the absence of expiry dates. In case you are wondering, a futures contract is an agreement between two people to buy or sell an asset at a predetermined price at a specified time in the future.
The only purpose of a perpetual futures contract is to speculate on the price of assets. The first perpetual futures offered exposure to the BTC/USD pair in 2015, according to Bitstamp. Since then, the perpetual futures has undergone significant expansion and adoption, spreading to Africa
How are Perpetual Swaps and Futures Contracts Different?
| Crypto derivatives | Expiration date | Can hold position indefinitely | Funding rate mechanism |
| Perpetual swaps | No fixed expiration date | Yes | Yes |
| Futures contracts | Fixed expiration date | No | No |
Though perpetual swaps and futures contracts are both crypto derivatives, there are also some differences between the two. Let’s begin with the similarities.
The similarities between perpetual swaps and futures contracts include:
- Leverage: They both support leverage trading, meaning you can amplify your exposure to the underlying asset to enjoy substantial profits even with small capital.
- No custody: Since traders only speculate on future price movements, there is no custody of underlying assets.
- Long and short: You can hold a long or short position, depending on your perception of the market’s movement.
On the other hand, there are critical differences between perpetual swaps and futures contracts. First, perpetual swaps have no fixed expiration date, while futures contracts do. Additionally, positions can be held indefinitely in perpetual swaps but not in futures contracts.
Furthermore, perpetual swaps incorporate a funding rate mechanism that is intended to keep their prices closely tied to the spot market price of underlying assets. Futures contracts, on the other hand, have no funding rate as the contract is settled after expiration.
Inverse Perpetual Swaps in Crypto Trading
Inverse perpetual swaps are another type of financial instrument used in crypto trading. Inverse perpetual swaps in crypto trading are traded based on the underlying cryptocurrency. Inverse perpetual swaps are a variation of conventional perpetual swaps but with a distinct feature.
While the contract value of a standard perpetual swap moves in tandem with the price of the underlying assets, an inverse perpetual swap moves the other way around. The contract value in inverse perpetual swaps moves inversely with the price of the underlying asset. For instance, if the price of Bitcoin (BTC) increases, the value of an inverse Bitcoin perpetual swap will decrease, and vice versa.
Inverse perpetual swaps come in handy as a hedging strategy. It enables traders to mitigate potential losses in a highly volatile market. For instance, inverse perpetual swaps can be employed to reduce potential losses in your spot position when the market faces bearish sentiment.
Funding Rate Mechanism’s Role in Perpetual Swaps
The funding rate mechanism’s role in perpetual swaps is crucial. Perpetual swaps track the price of an underlying asset without an expiration date. As a result of the absence of expiration dates in perpetual swaps, there is a need to align prices, which is where the funding rate mechanism comes in.
The funding rate mechanism plays a crucial role in perpetual swaps by aligning the contract with the market price of the underlying asset. This will help to maintain fair and balanced market conditions while allowing traders to hold either long or short positions indefinitely.
Here is an example of how the funding rate mechanism works. Say, for example, that the price of Bitcoin is $30,000; the funding rate mechanism will ensure that the price of the perpetual swap contract is also at the same $30,000 level.
Perpetual Swaps Vs CFDs
You might be curious about perpetual swaps vs CFDs. Read along.
Perpetual Swaps
By now, you should know what perpetual swaps are off the top of your head. But here is another refresher: perpetual swaps are similar to futures contracts but without an expiration date; that is, you can hold positions indefinitely.
Contracts for Difference (CFDs)
Contracts for Difference (CFDs) enable traders to trade the price movement of cryptos without having to own the underlying asset. CFDs are financial agreements between traders and brokers to exchange the difference between the price of an underlying asset at the time the contract is opened and when it is closed. Leveraged positions can be held, just like in perpetual swaps.
Differences Between Perpetual Swaps and CFDs
| Underlying assets | Settlement date | Funding rate | |
| Perpetual swaps | Typically cryptocurrencies. | No, positions can be held indefinitely. | Yes |
| Contracts for Differences (CFDs) | Cryptocurrencies, stocks, commodities, etc. | Yes, the position must be closed or the contract settled. | No |
Perpetual swaps and CFDs are popular derivative contracts that enable traders to speculate on the price movement of assets. Although they are both derivatives, they have their key differences, which have been explained above.
How do you Open a Perpetual Swap Position?
I will provide you with a guide on how to open a perpetual swap position. Read along.
- Choose a Crypto Trading Platform: Ensure it is a reputable exchange platform that offers perpetual swaps and has the perpetual swap contracts you would like to trade. Binance, OKX, and Bybit are some of the top derivatives platforms you can check out.
- Select Perpetual Swap Contract: After funding your trading account, select the perpetual swap contract pair you wish to trade, e.g., BTC/USD or ETH/USD.
- Set the Size of your Position: Choose leverage.
- Choose either a long or Short position. Decide whether you expect a rise in price (long) or a fall in price (short).
- Set Stop-Loss and Take-Profit: This is a risk management tool that helps reduce potential loss and secure profit.
- Monitor your Trade: Closely monitor the trade and the market movement.
The above explains how to open a perpetual swap position. If you wish to close your position, click on “close” or “sell.”
What are the Pros and Cons of Perpetual Swaps?
While perpetual swaps have become a crucial item in traders’ arsenals, they come with their own set of pros and cons.
Pros
- No expiration: Perpetual swaps don’t have fixed expiration dates.
- Leveraged trading: You can amplify your exposure to and profits from underlying assets by using leverage.
- Long and short positions: You can speculate on the price of an underlying crypto asset rising or falling.
- Price tracking: You will be able to track the spot market prices of underlying assets thanks to the funding rate mechanism.
Cons
- High Risk: The volatility of the crypto market and leverage make perpetual swaps high-risk, as the latter amplifies losses as well as profits.
- Complexity: It can be more challenging than spot trading, particularly for new traders.
- Susceptibility to market manipulation: The market and funding rate mechanisms can be manipulated by large traders, making them high-risk.
How Does Perpetual Swap Trading Work?
Perpetual swap trading begins just like every trade: funding your wallet with crypto assets, which will serve as collateral. There are perpetual swap contracts for different assets with their contract specifications, e.g., BTC/USD.
By choosing your leverage selection and opening a long or short position, you will determine your exposure to the market. There are four prices relevant to every leveraged trade: entry, bankruptcy, liquidation, and closing prices.
The entry price is the price at which the perpetual swap trade is opened, while the closing price is the average price at which the trade is closed. A bankruptcy price is a period when the loss on a trade is equal to the value of the collateral. The liquidation price is the price per contract at which liquidation occurs.
Risk management via stop-loss and take-profit will help you manage high volatility and leverage. Lastly, settlement and profit and loss (P&L) calculations for perpetual swaps are done in real time based on the difference between the entry and exit prices of the position.
Can Perpetual Swaps be Terminated?
While perpetual swaps don’t have a fixed expiration date and are designed to operate indefinitely, they are often terminated either by the trader or through forced liquidation.
As a trader, you can exit or close your position at any time before or after the contract would naturally end. To exit a perpetual swap position, you only need to make the opposite trade of your initial entry. This will cancel your position and end the contract.
Forced liquidation is another common way perpetual swaps can be terminated. This means your trading margin balance falls below the required maintenance margin, and liquidation is forced to prevent default.
Additionally, perpetual swaps contracts can be delisted by exchanges, with open positions terminated. Also, if contracts are updated or modified, it could lead to the termination of an existing contract.
In some rare cases, perpetual swaps can be terminated due to technical issues or problems on the exchange platform, pending the resolution of the issues.
Why are Perpetual Swaps so Useful?
I earlier hinted at how perpetual swaps are an upgrade on traditional futures contracts, thereby offering numerous advantages to traders. Imagine having to trade crypto assets while grappling with the risks of holding assets or trading without leverage. It is baffling at this point based on how much the crypto landscape has evolved.
Perpetual swaps come in handy for several reasons. They include:
- No contract expiration: Perpetual swaps do not have fixed expiry dates, making them a great long-term trade strategy.
- Underlying assets: Perpetual swaps allow the purchase and sale of underlying assets but not the asset itself. This absolves traders of the risk that comes with holding and trading real assets.
- Continuous trading: It operates 24/7, providing 24/7 access to the market.
- Leverage: Leveraged trading is supported by perpetual swaps, which amplify exposure to the underlying assets, resulting in higher potential profits.
- Hedging opportunity: Perpetual swaps can be used for hedging purposes.
Final Thoughts on Perpetual Swaps in Crypto
In conclusion, perpetual swaps emergence has helped traders navigate the volatile world of crypto and revolutionized the space. The flexible and powerful tool aids traders in speculating on the price movement of underlying assets without owning the assets.
As one of the types of crypto derivatives alongside future contracts, options contracts, and CFDs, perpetual swaps share many similarities with these derivatives but with some key distinctions. These include the fact that a perpetual swap contract doesn’t expire as long as it isn’t terminated and has a funding rate mechanism.
The continuous trading feature of perpetual swaps, leveraged trading, and the absence of fixed expiration dates appeal to crypto traders, seasoned and novice alike. Nevertheless, perpetual swaps need to be approached with caution and proper risk management due to leverage and the inherent risk of the crypto market.