What are Perpetual Futures or "Perps"

Introduction:

Economist Robert Shiller first proposed the concept of perpetual futures in 1993, but the financial technology was first implemented for cryptocurrency trading by co-founder Arthur Hayes and his team at the BitMEX exchange in 2016.

The concept and its crypto application

Initial theory:

Shiller proposed perpetual futures as a financial tool to create derivatives markets for illiquid, hard-to-value assets, such as real estate or labor income.

Crypto implementation:

Legendary options trader Arthur Hayes, the first billionaire Cryptocurrency Options Trader, and his team at BitMEX adapted this theoretical instrument to the crypto market. - In May 2016, they introduced the XBTUSD perpetual swap, a futures-like contract that could be held indefinitely instead of expiring monthly.

How BitMEX innovated the contract

BitMEX's version of the perpetual future contract became widely adopted by other crypto exchanges due to its specific mechanics.

Funding payments:

To prevent the perpetual contract's price from diverging significantly from the spot price of the underlying asset (like Bitcoin), BitMEX implemented a "funding rate." This mechanism involves periodic payments between traders holding long and short positions to keep the contract price tethered to the spot price.

High leverage:

The contracts also broke new ground by allowing for extremely high leverage, up to 100x, which created significant opportunities for traders.

Impact:

This innovation eliminated the need for traders to roll over contracts monthly and made perpetual futures the most traded financial instrument in the crypto market today.

Funding Rate

The funding rate is a unique mechanism in perpetual futures that serves to keep the contract's price closely aligned with the underlying asset's spot price.

Unlike traditional futures, which naturally converge to the spot price on their expiration date, perpetual futures never expire, so a system is needed to prevent the futures and spot prices from diverging significantly.

Here is how the funding rate mechanism works:

The core purpose

The funding rate creates a regular, periodic payment between traders holding long and short positions to balance market sentiment.
This payment incentivizes market participants to push the perpetual contract's price toward the spot price, or index price, of the underlying asset.
It is not a fee paid to the exchange; rather, it is a direct transfer between traders.

Positive funding rate

A positive funding rate occurs when the perpetual futures price is trading above the spot price. Contango
- This situation, known as contango, indicates that bullish sentiment is prevalent, and more traders are taking long positions.*

The payment:

Traders holding long positions must pay a fee to traders holding short positions.

The incentive:

This dynamic makes it more expensive to hold a long position and more profitable to hold a short position.
As a result, it encourages sellers to enter the market and pushes the futures price back down toward the spot price.

Negative funding rate

A negative funding rate occurs when the perpetual futures price is trading below the spot price. Backwardation
This is known as backwardation, and it signifies that bearish sentiment is strong, with more traders holding short positions.

The payment:

Traders holding short positions must pay a fee to traders holding long positions.

The incentive:

This makes it more expensive to hold a short position, encouraging traders to close their shorts or open long positions, which pushes the perpetual contract's price back up toward the spot price.

How the rate is calculated

While the exact formula can vary by exchange, it is generally based on two components: the premium index and an interest rate.

Premium index:

Measures the difference between the perpetual contract's price and the underlying asset's spot price.
It is the primary driver of whether the rate is positive or negative.

Interest rate:

A fixed rate determined by the exchange.
The formula may include a clamping function to prevent extreme spikes in the funding rate, ensuring a more stable and predictable environment for traders.

Impact on traders

For traders, the funding rate is an important factor to consider for their overall profitability, especially for high-leverage positions held over an extended period.

For long-term holders:

A consistently positive funding rate can significantly erode profits for a long position, while a negative rate can add to the profitability of a short position.

For market analysts:

The funding rate can act as a barometer for market sentiment, as extreme positive or negative rates can signal an over-leveraged market or impending short squeeze.

For arbitrageurs:

Traders can employ a delta-neutral strategy, or "cash and carry," to profit from the funding rate.
For example, if the funding rate is positive, a trader can buy the spot asset while simultaneously shorting the perpetual futures contract.
They collect the funding payments while remaining insulated from price volatility.
Learn as much as you can and consider paper trading until you are confident you can win.
Only trade what you can afford to lose.
-Remember you wins are yours and your losses are yours. Take full responsibility for your actions.