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.
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:
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.
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 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:
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
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:
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 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.
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.
You might be curious about perpetual swaps vs CFDs. Read along.
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) 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.
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.
I will provide you with a guide on how to open a perpetual swap position. Read along.
The above explains how to open a perpetual swap position. If you wish to close your position, click on “close” or “sell.”
While perpetual swaps have become a crucial item in traders’ arsenals, they come with their own set of pros and cons.
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.
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.
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:
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.