Perpetual Swaps 101

The explanations and examples in this article are created by our community member JohanWalem4#3838.

1. What is a futures contract and how does it work?

A futures contract is an agreement that allows the holder of the futures contract to buy or sell the underlying asset at a fixed price on a future date.

Example:

Suppose you have grown and harvested 100 kilograms (kg) of wheat today, and you think the price of wheat can go up from $10/kg today to $20/kg in 3 months (for any reason such as a shortage of wheat, or more demand for wheat in 3 months).

You can buy a futures contract to sell 100 kg of wheat in 3 months at $20/kg. On the expiry date of this contract, you can exercise it and sell the wheat at the agreed upon price.

2. How is a perpetual swap different or similar to a futures contract and how does it work?

A perpetual swap is a futures contract that does not have a fixed expiry date.

Example:

In the above wheat example, instead of a 3 month expiry futures contract, a perpetual wheat contract will not have an expiry date. In most cases, the price of a perpetual swap will tend to have strong correlation with the spot price of the asset. Thus, you can use perpetual swaps to have exposure to an asset without holding it in the spot market (spot market trades assets for immediate delivery). For example, in the case of oil, it could be difficult to have exposure to spot oil as you would have to spend additional costs for storage. In this case, a perpetual oil contract allows you to have exposure to the price of the underlying asset (oil) without holding it in spot markets.

3. Explain what funding payments are — a core mechanism of a perpetual swap.

The funding rate is the mechanism used to keep the price of the perpetual swap contracts close to the price of the spot asset. The funding mechanism balances buyers and sellers, this helps in maintaining an equilibrium between the longs and shorts and keeps the perpetual price stable with the spot price.

Funding payments are the costs that buyers and sellers incur while trading perpetual contracts. A positive funding rate implies that the holders of the long perpetual contracts have to pay the holders of the short perpetual contracts. A negative funding rate implies the holders of the short perpetual contracts will have to pay to holders of the long perpetual contracts. The funding rate goes up and down depending on the deviation of the perpetual price with the spot price.

Example:

If the wheat spot price is trading at $10 while the wheat perpetual contract is trading at $11, the funding rate will be positive. This implies holders of long wheat perpetual contracts will have to pay those holding short wheat perpetual contracts. This mechanism will discourage those longing wheat, as they will have to pay more. Thus, the price of the perpetual contract will return to the spot price and close the gap.

4. How can you profit or lose from funding payments?

You can profit or lose from funding payments by taking directional positions based on the funding rate. If the funding rate is positive, holders of long perpetual contracts have to pay holders of short perpetual contracts. This means if you hold long contracts while the funding rate is positive, you are paying interest while holding your position. However when the funding rate is positive and you are holding short perp contracts, you will earn interest income paid by those holding long perpetual contracts. Thus you can profit or lose from funding payments.

5. What is leverage? What are some of the benefits and risks of using leverage?

Leverage allows traders to take a large position size with smaller capital by putting up a suitable amount of collateral.

Example:

Suppose you want to have exposure to 100 kg of wheat futures, you can put up a collateral of 10 kg wheat, and take a margined position of 100 kg without having spot exposure to the entire 100 kg. The benefits of using leverage is that it helps traders become capital efficient and have increased exposure at a lower cost. Risks of using leverage is that it can result in losing your collateral capital if the price moves very quickly due to volatility. When using leverage, sound risk management principles must be employed.

6. What is arbitrage? Explain how you can profit or lose from arbitrage opportunities in a perpetuals market.

Arbitrage is the practice of buying and selling assets or commodities in multiple markets to take advantage of the price difference in markets.

Example:

A trader can profit from arbitrage opportunities if there is a difference between the perpetual market price and the spot market price. For example, if wheat is trading at $10 in the spot market and $11 in the perpetual market, a trader can hold a short position in the perpetual market, while buying wheat in the spot market. After a few days, if the price converges on both markets to $12, then the trader would have made a loss of $1 in their perpetual position, but a gain of $2 in their spot position. Thus their net gain would be $1 i.e. they have profited from arbitrage opportunities. However if the price does not converge, they may incur losses and the longer the price does not converge, they may incur additional funding payments too which will add to their expenses.

7. At a high-level, explain a specific event where you would use forex or crypto perpetuals to speculate on or hedge your assets.

You can use perpetuals to hedge your assets if you think the price of the underlying asset will change based on economic outlook. For example, if you hold CAD (Canadian Dollars) and think that the CAD will lose its value vs the USD in the next 6 months due to economic factors, you can use CAD perpetuals to hedge your exposure to the price risk.

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Originally published at https://increment.substack.com on June 14, 2022.