Understanding Futures Contracts
A futures contract is a standardized agreement to buy or sell an asset (commodity, currency, or financial instrument) at a predetermined price on a specified future date. Unlike spot markets, where trades settle immediately, futures markets involve deferred settlement. Traders exchange contracts representing the underlying asset, with physical or cash settlement occurring later.
Key Features:
- Physical vs. Cash Settlement: Some futures (e.g., gold, wheat) may require physical delivery, incurring storage/transport costs. Most modern futures use cash settlement.
- Price Dynamics: Futures prices vary based on settlement date proximity, carrying costs, and market uncertainty.
Why Trade Futures Contracts?
- Hedging & Risk Management: Originally designed to mitigate price volatility risks.
- Short Selling: Profit from asset price declines without owning the asset.
- Leverage: Amplify exposure with a fraction of the total position value.
Perpetual Futures Contracts Explained
Perpetual futures are a unique derivative without an expiry date, allowing indefinite position holding. They track an Index Price derived from major spot markets’ volume-weighted averages.
Key Differences vs. Traditional Futures:
- No Expiry: Eliminates rolling contracts or settlement dates.
- Price Alignment: Typically trades close to spot prices, with deviations during extreme volatility.
Margin and Liquidation
Initial Margin
The minimum collateral required to open a leveraged position (e.g., 10% for 10x leverage). Acts as a safety buffer for the exchange.
Maintenance Margin
The minimum collateral to keep a position open. Falling below this triggers liquidation.
👉 Learn how to manage margin risks
Liquidation
Occurs when collateral drops below maintenance margin. Traders can:
- Add funds to adjust the liquidation price.
- Close positions preemptively.
Funding Rate Mechanism
Perpetual contracts use funding payments to tether prices to spot markets:
- Positive Rate: Longs pay shorts (contracts trading at a premium).
- Negative Rate: Shorts pay longs (contracts trading at a discount).
Calculated from:
- Interest Rate: Exchange-specific.
- Premium: Futures-spot price gap.
Key Pricing Concepts
Mark Price
A "fair value" estimate preventing unfair liquidations during volatility. Combines:
- Index Price (spot market average).
- Funding Rate.
PnL (Profit and Loss)
- Unrealized PnL: Fluctuates with open positions.
- Realized PnL: Locked in upon closing positions.
Risk Management Tools
Insurance Fund
Covers deficits when liquidations fail to fully offset losses. Funded by:
- Liquidation fees.
- Excess collateral from liquidated traders.
👉 Explore advanced risk strategies
Auto-Deleveraging (ADL)
A last-resort mechanism where profitable traders cover bankrupt positions if the Insurance Fund is exhausted. Rare but possible during extreme volatility.
FAQs
1. Can perpetual futures expire?
No. They lack expiry dates, unlike traditional futures.
2. How does leverage affect liquidation risk?
Higher leverage = lower margin buffer = liquidation price closer to entry.
3. Why does the funding rate matter?
It incentivizes arbitrage to align perpetual and spot prices.
4. What happens during liquidation?
The exchange closes your position, and collateral is lost.
5. How is the Mark Price calculated?
From the Index Price + funding rate adjustments.
6. Is the Insurance Fund always sufficient?
Usually, but ADL may activate in extreme scenarios.