What are Perpetual Contracts (PERPS)?

Perpetual Contracts (PERPS)

Perpetual contracts, also known as perpetual swaps or simply “perps,” are a type of derivative contract that allows traders to speculate on the price of a particular asset without having to physically own the underlying asset. Perpetual contracts are a type of financial instrument that are used to hedge risk or to speculate on the price movement of an asset.

In the context of cryptocurrency, perpetual contracts are futures contracts that do not have an expiration date. This means that they can be held indefinitely by a trader, as long as they have the necessary margin to cover any potential losses. Perpetual contracts are typically settled in cryptocurrency, which means that they can be traded on cryptocurrency exchanges.

How do Perpetual Contracts work?

To understand how perpetual contracts work, it is helpful to first understand the basics of futures contracts. A futures contract is an agreement between two parties to buy or sell a certain asset at a specified price on a specific date in the future. Futures contracts are typically used by traders to speculate on the price movement of an asset or to hedge against potential price fluctuations.

Perpetual contracts are similar to traditional futures contracts, but they differ in a few key ways. First, traditional futures contracts have a specific expiration date, at which point the contract must be settled. This means that traders must either take delivery of the underlying asset or close out their position before the expiration date. Perpetual contracts, on the other hand, do not have an expiration date, so traders can hold onto their positions indefinitely.

To enter into a perpetual contract, a trader must first deposit a certain amount of margin, which is essentially a good faith deposit that is used to cover any potential losses. The amount of margin required will depend on the size of the trade and the level of leverage being used.

Once the trader has deposited their margin, they can enter into a perpetual contract by either buying (going long) or selling (going short) the underlying asset. For example, if a trader believes that the price of Bitcoin will go up, they might enter into a perpetual contract by buying Bitcoin. If the price of Bitcoin does indeed go up, the trader will make a profit. If the price of Bitcoin goes down, the trader will incur a loss.

Another key difference between perpetual contracts and traditional futures contracts is the way in which they are settled. Traditional futures contracts are settled through delivery of the underlying asset, whereas perpetual contracts are typically settled in cryptocurrency. This means that traders do not have to worry about the logistics of physically taking delivery of the underlying asset.

Perpetual contracts are often used as a way to speculate on the price of a particular asset, such as Bitcoin or Ethereum. They can also be used to hedge against price fluctuations in the underlying asset. For example, if a trader is holding a large position in Bitcoin and is concerned about the potential for price declines, they could use a perpetual contract to hedge against potential losses.

Perpetual contracts are also popular among traders because they offer high leverage, which means that traders can potentially make larger profits (or losses) with a smaller initial investment. However, the use of high leverage can also increase the risk of losses, so traders should be careful when using these types of contracts.

One potential drawback of perpetual contracts is the risk of counterparty default. Because these contracts are not backed by a central clearinghouse, there is a risk that one of the parties involved in the contract will default on their obligations. This can lead to losses for the other party, especially if the defaulting party has a large position. 

Spot trading vs Futures trading

What is the difference between ‘Spot’ and ‘Futures’?

In the world of cryptocurrency, the terms “spot” and “futures” refer to different ways of buying and selling digital assets. Understanding the differences between these two types of transactions can be helpful for traders who are looking to enter the cryptocurrency market.

Spot transactions, also known as “spot trades,” are the most common type of cryptocurrency trade. In a spot trade, a buyer and seller agree to exchange a certain amount of cryptocurrency at the current market price. The transaction is typically settled within a few hours, or in some cases, within a few days.

One of the key characteristics of spot trades is that they involve the immediate delivery of the underlying asset. This means that once a spot trade is completed, the buyer takes ownership of the cryptocurrency and the seller relinquishes ownership.

Spot trades are popular among traders because they offer a simple and straightforward way to buy and sell cryptocurrency. They are also relatively low-risk, as the transaction is settled relatively quickly and the price of the cryptocurrency is determined at the time of the trade.

Futures contracts, on the other hand, are a type of derivative contract that allows traders to speculate on the future price of an asset. In a futures contract, a buyer and seller agree to exchange a certain amount of an underlying asset at a specified price on a specific date in the future.

Futures contracts are used by traders to speculate on the price movement of an asset, or to hedge against potential price fluctuations. For example, a trader who is concerned about the potential for a decline in the price of Bitcoin might enter into a futures contract to sell Bitcoin at a certain price on a specific date in the future.

One of the key differences between spot trades and futures contracts is the settlement date. In a spot trade, the transaction is typically settled within a few hours or days, whereas in a futures contract, the transaction is settled on a specific date in the future. This means that traders who enter into a futures contract are taking on the risk of price fluctuations between the time the contract is entered into and the settlement date.

Another difference between spot trades and futures contracts is the level of leverage that is available. Futures contracts often offer higher leverage than spot trades, which means that traders can potentially make larger profits (or losses) with a smaller initial investment. However, the use of high leverage can also increase the risk of losses, so traders should be careful when using these types of contracts.

Examples of how ‘Perpetual Contracts’ might be used in the world of cryptocurrency

Example 1: Speculating on the price of Bitcoin

Suppose that a trader believes that the price of Bitcoin will go up in the near future. They might decide to enter into a perpetual contract by buying (going long) a certain amount of Bitcoin. If the price of Bitcoin does indeed go up, the trader will make a profit. For example, if the trader buys 1 Bitcoin at a price of $50,000 and the price goes up to $60,000, they will have made a profit of $10,000.

On the other hand, if the price of Bitcoin goes down instead of up, the trader will incur a loss. For example, if the trader buys 1 Bitcoin at a price of $50,000 and the price goes down to $40,000, they will have incurred a loss of $10,000.

Example 2: Hedging against price fluctuations in Ethereum

Suppose that a trader is holding a large position in Ethereum and is concerned about the potential for price declines. They might decide to enter into a perpetual contract by selling (going short) a certain amount of Ethereum. If the price of Ethereum does indeed go down, the trader will make a profit from their short position, which will offset any losses from their long position.

For example, if the trader is holding 1,000 Ethereum worth $500,000 and the price goes down to $400,000, they will have incurred a loss of $100,000 on their long position. However, if they have also sold 1,000 Ethereum through a perpetual contract at a price of $500,000, they will have made a profit of $100,000 on their short position, which will offset their losses on their long position.

In this way, the trader has used a perpetual contract to hedge against potential price declines in Ethereum.

Example 3: Using leverage to maximize profits

Suppose that a trader believes that the price of Bitcoin will go up significantly in the near future and wants to maximize their profits. They might decide to enter into a perpetual contract with a high level of leverage, which will allow them to control a larger position with a smaller initial investment.

For example, suppose that the trader has $10,000 to invest and wants to buy as much Bitcoin as possible. They might decide to enter into a perpetual contract with a leverage of 10x, which will allow them to control a position worth $100,000 with their $10,000 investment. If the price of Bitcoin goes up significantly, the trader will be able to make a large profit on their investment.

However, it is important to note that the use of high leverage can also increase the risk of losses. If the price of Bitcoin goes down instead of up, the trader will incur a loss that is proportionally larger than their initial investment. For this reason, traders should be careful when using leverage and should only use it if they are comfortable with the potential risks.

Pros of using perpetual contracts in cryptocurrency:

  • The ability to speculate on the price of an asset without having to physically own it: Perpetual contracts allow traders to speculate on the price of an asset without actually having to purchase the underlying asset. This can be useful for traders who want to take a position on the price of an asset without the expense or hassle of actually owning it.
  • The ability to hedge against price fluctuations: Perpetual contracts can be used as a way to hedge against potential price fluctuations in an underlying asset. For example, a trader who is holding a large position in Bitcoin and is concerned about the potential for price declines might enter into a perpetual contract to sell Bitcoin as a way to protect against potential losses.
  • High leverage: Perpetual contracts often offer high leverage, which means that traders can potentially make larger profits (or losses) with a smaller initial investment. This can be useful for traders who want to maximize their returns but don’t have a large amount of capital to invest.
  • Ease of use: Perpetual contracts can be traded on cryptocurrency exchanges, which makes them easy to access for traders.

Cons of using perpetual contracts in cryptocurrency:

  • Risk of counterparty default: Because perpetual contracts are not backed by a central clearinghouse, there is a risk that one of the parties involved in the contract will default on their obligations. This can lead to losses for the other party, especially if the defaulting party has a large position.
  • Risk of liquidation: If a trader’s position becomes too large or the market moves against them, they may be required to deposit additional margin to cover their losses. If they are unable to do so, their position may be liquidated, which means that it will be closed out and they will incur a loss.
  • Complexity: Perpetual contracts can be complex financial instruments, and traders may need to have a solid understanding of derivatives and risk management to use them effectively.
  • The potential for large losses: The use of high leverage can increase the potential for large losses, especially if the market moves against a trader’s position. This means that traders should be careful when using perpetual contracts and should only use them if they are comfortable with the potential risks.
  • Lack of regulation: Perpetual contracts are not regulated in the same way as traditional financial instruments, which means that there is less oversight and protection for traders. This can be a concern for traders who are worried about the security of their investments.

Arbitrage opportunities when using ‘Perpetual Contracts’

Arbitrage opportunities refer to situations where it is possible to buy an asset at a low price in one market and sell it for a higher price in another market. In the context of perpetual contracts in cryptocurrency, arbitrage opportunities may arise when the price of a particular asset differs between different exchanges or platforms.

For example, suppose that the price of Bitcoin is $10,000 on Exchange A and $10,500 on Exchange B. A trader who is aware of this price difference might decide to buy Bitcoin on Exchange A and sell it on Exchange B, thereby earning a profit of $500. This is an example of arbitrage, as the trader is taking advantage of the price difference between the two exchanges to make a profit.

In the case of perpetual contracts, arbitrage opportunities may also arise when the price of a particular asset differs between different perpetual contracts on the same exchange. For example, suppose that the price of Bitcoin is $10,000 on a perpetual contract with a leverage of 10x and $9,500 on a perpetual contract with a leverage of 20x. A trader who is aware of this price difference might decide to buy Bitcoin on the 10x leverage contract and sell it on the 20x leverage contract, thereby earning a profit of $500.

To take advantage of arbitrage opportunities in the context of perpetual contracts, traders typically need to have access to multiple exchanges or platforms and be able to move funds between them quickly. They may also need to have a solid understanding of market conditions and be able to identify potential price discrepancies in real-time.

It is important to note that arbitrage opportunities may not always be easy to find or take advantage of. In some cases, the price difference between different exchanges or contracts may be small, making it difficult to turn a profit. Additionally, the process of buying and selling assets on multiple exchanges can be time-consuming and costly, as it may involve fees for trading, transferring funds, and other expenses.

Last updated Dec 27, 2022

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