Part 1
Perpetual Futures – Crypto's Hottest, New Thing
Have you ever made a bet with someone but instead of having a set deadline, it just stays open—no end date? It’s just an ongoing bet that either of you could close whenever you wanted?
Perpetual futures allow you to do precisely that.
Even though it might sound simple, the mechanics behind it and the impact it has on financial markets are changing the game on how the world trades.
Futures contracts:
To understand the mechanics behind perps, we need to know what futures are and why they matter.
Futures are binding agreements between two parties to buy or sell something at a set price for a future date, with the obligation (in principle) to deliver or receive the asset when that date arrives.
Imagine a scenario where you and a friend come to agreement where you agree to sell a concert ticket for $100 in one month, no matter if the value of the ticket goes up or down by then. Once that month is up, the deal is settled and you are obligated to deliver the ticket. If the concert gets sold out and increases the value to $200, your friend wins. However, if the demand for the concert drops the ticket price to $50, you win because you’re able to make a profit.
One major difference between future contracts and perpetual futures (perps) is the ending date. Every futures contract has a set expiration date when the contract closes, and both sides have to settle up—no matter what. Perpetual futures remove that date entirely. There is no expiration date, and you can hold your position open for as long as you want, indefinitely.
The Funding Rate:
Think of a boat. If everyone goes to one side of the boat, it tilts. The only way to keep the boat from sinking is by finding an equilibrium where the right number of people are on each side.
The funding rate is the mechanism behind how to keep the boat stable. It adjusts what is necessary to bring balance to both sides.
How does this work in the context of perpetual futures?
There are two components that go into the funding rate.
- Interest rate: There is typically a fixed rate of 0.01% per interval, which depending on the platform, reflects the baseline cost of holding a position set by the exchange and does not change regardless of market conditions.
- The premium index: The difference between the perpetual contract price and the spot price. This is the variable part that determines who pays who.
That rate is paid every eight hours (00:00, 8:00 and 16:00 UTC) between the two parties of trade and not to the platform. Who pays whom is dependent on whether the future price is higher or lower than the spot price. That is where longs and shorts come into play. These two sides are always on opposite ends of every trade with one side collecting and the other on the hook for.
- A long trader bets the price will go up. Generally, they profit if the price goes up and lose if the price falls.
- A short trader is the opposite and bets the stock will lose value, profiting when price drops and loses if it goes up.
The concept most people miss is that the funding rate is not just a cost, but a paycheck to the ones on the unpopular side. This is the most important thing.
If a majority of traders are long on an asset, the futures contract will trade at a premium (price drifts above its actual value), longs will have to pay a higher fee to the ones that are short.
Thus, you can be right about the direction and still lose from funding fees if more people pile onto your side, because you have to pay the losing side. When funding rates climb extremely high, it is warning that one side of the ‘boat’ is overcrowded.
Therefore, some traders do not even care which direction the price moves but specifically position themselves on the side less crowded to collect the reoccurring fee.
