What are Perpetual Contracts and Funding Rates?

In traditional trading, a “futures contract” is when you buy the right to purchase an underlying asset at a specified price at some future date. For example, you can enter into a contract to buy 5,000 bushels of corn at $7.50 an ounce in six months’ time. The farmer has a bit of risk because the price of corn might go up, but at least he will be guaranteed a sale if the market goes down. This helps keep unpredictable industries such as agriculture alive.

At the end of 6 months, you must pay your $7.50 and you will receive 5,000 bushels of corn at your door! Seeing as most traders aren’t actually interested in receiving corn at their doorsteps, traders get around this by trading futures contracts amongst each other.

The important thing to know is that the futures market has an expiration date for contracts.

There is another type of trading market called the options market, which is also a type of futures market. But in the options market, someone buys the option to buy the corn, not the obligation. Options also have an expiration date.

These products are called derivative products because their price is derived from an underlying asset (corn, in our examples).

Perpetual futures contracts — those without any expiration date — are only possible in cryptocurrency. Perpetual futures have no expiration date.

Only through the technology of cryptocurrency was it possible to achieve a futures contract which does not have an expiration date and can be held perpetually.

What is a perpetual futures contract?

Many traditional futures contracts are settled for cash before the expiration date. This is called a cash settlement.

In cryptocurrency, it’s possible to trade in futures derivatives using underlying cryptocurrency assets. For example, you could offer to buy 10 BTC in three months at $25,000 each. The seller of the futures contract agrees to the sale and then must sell you 10 BTC on the contract’s expiration date, regardless of BTC’s price. And you must buy.

If BTC goes up to $26,000, you gain $1,000 per BTC and the seller loses $1,000 per BTC.

You can take out both long and short positions on futures contracts. A “long” position is when you think an asset is going to go up in price. A “short” position is when you think it is going to go down.

Because traditional futures contracts always come to an end, the futures contract price is regularly brought into line with the underlying spot index price. In a perpetual futures contract, this isn’t possible, and open futures contracts might diverge quite drastically from spot index prices. This would in turn cause an imbalance in the market — those who are long would stay long and never close their positions, and vice versa for shorts.

These days, you can open up perpetual futures contracts on almost any CEX or DEX.

Perpetual futures let you go long or short on an underlying asset with enormous amounts of leverage, making it a far more attractive option than simple margin trading.

What is the funding rate?

Perpetuals are possible only because of the concept of the funding rate. By implementing a funding rate, it is possible to keep the perpetual futures trade price in line with the underlying index price.

Perpetuals are not actually “perpetual.” They automatically roll over every few hours. The exact number of hours depends on the exchange you’re using, although it is usually 8 hours. When the contract rolls over, the exchange calculates the difference between the index price and trade price(mark price) and then calculates a funding rate to be charged. Each exchange does this according to its own algorithms.

When the trade price is higher than the index price, the funding rate is positive and longs pay shorts. When the trade price is lower than the index price, the funding rate goes negative and shorts pay the funding fee to longs.

In this way, the market can be held in balance, and the perpetual contract is able to exist.

The fee itself is usually quite small, but it does add up. The purpose is to encourage shorts and longs to abandon their positions because it starts getting too expensive, thereby bringing balance to the market.

How are perpetual futures contracts priced?

Each exchange has its own unique way of pricing its perpetual futures contracts but they all tend to follow, more or less, the following formula:

Trade Price = Index Price * (1 + Funding Rate)

Each exchange has its own method of calculating the index price and it roughly translates to the price of the underlying asset, such as ETH.

So, the above formula translates to:

Trade Price = ETH(1 + Funding Rate)

If the Funding Rate is negative (shorts pay longs) then the trade price will be lower than the index price.

But some CEXes and DEXes usually charge trading fees as well. They don’t always show this on the entry price so, when you finally do want to enter the position, you might end up paying more than what you initially saw on the quote.

Predy Finance shows you the entry price including fees so that there are no hidden costs when you decide to enter a position. This might make Predy quotes seem less competitive when in fact Predy is being more transparent.

How do perpetual futures work when you go long?

Perpetual futures never have a settlement date, so going long on them is like going long on any other type of asset. You buy it and hold it with the hopes of selling it at a later date for a higher return.

Perpetuals allow you to more easily take out highly leveraged positions, which means you borrow some capital from the exchange to execute larger trades and increase your potential profit while also minimizing risk on the underlying asset. When you go long on a perpetual and the market is rising, you also earn funding fees from those who have gone short.

How do perpetual futures work when you go short?

Short traders are betting on the underlying asset price going down.

By buying ETH and shorting ETH-Perpetual, you essentially earn Funding Payments from your shorted ETH-Perpetual (long holders will pay you funding fees) while the funding rate is positive. It’s an excellent way to achieve a high Annual Percentage Yield (APY).

How to start trading perpetuals

Predy Finance has made it easy to trade perpetuals using the Predy Finance app. Simply connect your wallet and use the simple interface to take out one of the many perpetual products available to you!