You’ve probably noticed Binance (and other platforms) have been offering futures, options, margin and leverage trading on top of their regular trading platform. If you’re not that familiar with trading you might scratch your head and wonder what this is all about.
In this article I will cover perpetual futures.
What are futures?
Futures are contracts, so basically they’re agreements to buy or sell a commodity, currency, or any other instrument at a predetermined price at a specified time in the future. In this case the underlying asset is cryptocurrency.
Simply put when you buy a future you are committing yourself to buy or sell cryptocurrency at a date in the future, hence the name future. You also often hear the name “derivative” in this context and this is because the value of a futures contract is derived from the underlying asset in this case cryptocurrency.
In markets such as trading wheat or gold goods are exchanged when the contracts are settled but these physical goods need to be transported and stored, this creates additional costs known as carrying costs. As you can imagine the price of those goods on the market today can differ from their price at the settlement date due to market fluctuations but also because of the carrying costs. The longer the time-gap the higher the carrying costs and the more the price can diverge from the current market price.
What are perpetual futures?
Unlike traditional futures perpetual futures don’t have an expiry date. There’s no obligation to settle at a certain date. In the case of Binance the underlying asset will be an “Index Price” of the cryptocurrency. This Index Price is an average price of the cryptocurrency based on the price on different spot markets (such as Binance itself) according to the volume and price of those markets. Unlike conventional futures, perpetual futures are traded at a price that’s very close to that of the spot market.
Why trade futures?
You might wonder if it follows price closely of that of the underlying crypto asset why bother trading futures. Why not directly trade the underlying crypto?
Futures offer some advantages over regular trading of cryptocurrency. For example you can trade using leverage. For example a 10x leverage.
Say you have 10 BNB in your account and the price of BNB moves from $15 to $15.1.
``` This means you made a profit of 10 x $(15.1 -15) = $1.
Imagine those 10 BNB allow you to trade with 100 BNB and the price of BNB moves from $15 to $15.1.
``` This means you made a profit of 100 x $(15.1 -15) = $10.
So even with small market fluctuations and a small trading budget you can make significant profits (or losses).
When you buy a house you receive a loan from the bank, the value of your house/land will act as collateral if ever you’re unable make your monthly payments the house can be sold to refund the loan and any additional costs.
Now your initial margin, those 10 BNB (which for simplicity’s sake we also consider our collateral) back your ‘loan’ of 90 BNB. If the value of your collateral falls below the maintenance margin and your account approaches a 10 BNB loss, your account will be liquidated because if it drops any further you wouldn’t be able to refund your ‘loan’ as you’d end up with less than 90 BNB.
Of course this example is a simplification to illustrate the principle of leverage and liquidation. In reality your initial margin and your collateral will not be the same but it helps to illustrate the principle.
On Binance, the liquidation occurs in different ways, according to the risk and leverage of each user (based on their collateral and net exposure).
Even without owning a certain crypto asset you can bet against its performance. Let’s illustrate this with a simple example.
Say you expect BNB to drop from $15.1 to $15, you can now open a short position. This means you can sell BNB (our underlying asset) without even having it in your account. Strictly speaking of course you’re not selling BNB but a future based upon it.
Basically when you sell 100 BNB at $15.1 imagine you give the buyer a note saying I’m going to give you 100 BNB at $15.1 at a later date. Then the price of BNB drops as you expected to $15 and you buy it for $15. Now is the time to honor your contract with the buyer for the predetermined price of $15.1. Since you’ve sold it for more than you bought it for you make a profit of $0.1 per BNB sold.
100 x $(15.1 -15) = $10
Note: I’m also simplifying the process here to illustrate the principle behind shorting.
What is the Funding rate?
Funding are payments between buyers and sellers, based on the current funding rate. A positive funding rate means the traders who are buying (long) contracts have to pay the ones who are selling (short) contracts, a negative funding rate means the opposite.
The funding rate consists of two components: the interest rate and the premium. On Binance futures market, the interest rate is fixed at 0.03%, and the premium is determined based on to the price difference between futures and spot markets.
When the perpetual futures contracts have a premium, in other words have a higher price than the spot markets, this premium (+ interest rate) will be paid to the short sellers by the long positions. Generally this tends to drive price down again to follow that of the spot markets as longs close their positions and new shorts are opened.
What is the mark price?
The mark price is an estimate of the true value of a contract (fair price) when compared to its actual trading price (last price). The mark price calculation prevents unfair liquidations that may happen when the market is highly volatile.
The mark price on Binance is based on the Index Price (the average price across different spot markets, see higher) and the funding rate, and it is also an essential part of the “unrealized PnL” calculation.
What is PnL?
PnL stands for profit and loss, and it can be either realized or unrealized. When you have open positions on a perpetual futures market, your PnL is unrealized, meaning it’s still changing in response to market moves. When you close your positions, the unrealized PnL becomes realized PnL (either partially or entirely).
Because the realized PnL refers to the profit or loss that originate from closed positions, it has no direct relation to the mark price, but only to the executed price of the orders. The unrealized PnL, on the other hand, is constantly changing and is the primary driver for liquidations. Thus, the mark price is used to ensure that the unrealized PnL calculation is accurate and just.
Insurance fund and Auto-deleveraging
Binance has also set up an insurance fund that uses collateral taken from liquidated traders and also uses auto-deleveraging to cover potential losses in case of extreme volatility.
How to trade perpetual futures?
You can trade the same way you trade spot markets, you only need to be more careful in managing your risk due to the higher risk of liquidation. And you have to keep in mind the additional costs involved.
One mistake many people make is wanting to continually trade regardless of where the market is at by guesstimating the direction of the market. This is just gambling and you’re gonna get burned sooner or later.
Planning your entry/exit and stop-loss are very important. Don’t enter a trade unless your strategy/indicators or resistance/support/pivots levels indicate an opportunity that has a good risk/reward ratio.
Personally I watch for specific patterns such as ascending wedges,certain candle formations like 3 white soldiers, Ichimoku cloud break-outs, indicators showing trend reversal or certain resistance levels to enter a trade. Having a system prevents you from emotionally chasing the market or gambling.
As discussed higher up depending on the market the funding rate is either positive or negative and either the long or the short positions will be compensated.
Say you have 100K euro in your bank account. Rather than keeping it in your bank account you could buy 100K worth of Bitcoin put that Bitcoin into your perpetual futures account and short Bitcoin at the price you bought it for.
This means regardless of the market movements you’re able to honor your contract since you already have the bitcoin available and settling the contract would just give you your initial investment back (minus costs to buy and transfer the money)
If the market goes up your bitcoin in your account gains in value and compensates for the loss on your short position while still accumulating premium. If the market goes down, your short position will gain and compensates the loss of your Bitcoin vs euro. However to avoid paying premium in that case you should close the short once the funding rate reverts to its mean.
There are a few other ways to take advantage of the differences in spot vs futures markets you could exploit as well but more on that later.
The above references an opinion and is for information purposes only. It is not intended to be investment advice and may contain affiliate links. Seek a duly licensed professional for investment advice.