Similar to futures contracts and contracts for difference, a perpetual contract is a derivatives product. Derivatives are agreements to buy or sell a position with the value derived from how this position is performing. However, perpetual contracts have a range of features that makes them different from futures contracts and other derivatives.
What Is Perpetual Contract?
A perpetual contract is a derivatives product that combines the features of futures trading and spot margin trading. Here are the features that characterize this type of contract:
- There is no expiration date or immediate settlement. Unlike futures contracts that require settlement on a certain date in the future and spot trading that requires immediate settlement, perpetual contracts do not have an expiration date. This feature makes it a perfect option for trade hedging, i.e. an ability to buy or sell the positions and hold them for an unlimited period of time. Perpetual contracts are also good for speculative trading. However, while the investors have no worries about any roll over costs or settlement fees, they should be aware of the funding periods. This is because they may have to pay a fee for holding a position.
- Trading is close to the underlying reference index price. It means that it is quite difficult to manipulate the price during the perpetual contract trading, i.e. intentionally inflate or deflate it. Instead of the last traded price that is used for other contracts as a liquidation trigger, perpetual contracts traders use the mark price as a reference to real-time spot transactions from major spot exchanges. The mark price also defines the unrealized PNL, i.e. the current profit and loss from all open positions.
- The leverage is flexible. In the regular spot margin market, the leverage is usually between 3 and 5x with the high borrowing costs. However, perpetual contracts can be offered at up to 100x leverage. The traders can adjust the leverage/margin of an open position at any time.
- The spot price is determined via funding, i.e. periodic payments that are exchanged between the buyer and seller every 8 hours. You will pay or receive funding only if you hold a position at a certain timestamp. There are three timestamps for perpetual contracts: 04:00 UTC, 12:00 UTC, and 20:00 UTC.
How to Calculate Funding for Perpetual Contracts
The funding that you pay or receive is calculated according to this formula:
Funding = Position Value x Funding Rate
- Position Value. The position value does not depend on leverage. The funding is charged or received on the notional value of the contracts that you hold. It is not based on the amount of margin that you have assigned to the position.
- Funding Rate. If the FR is positive, then the longs pay the shorts, and vice versa if the rate is negative.
How to Calculate Funding Rate
The purpose of the FR is to align the traded price of the perpetual contract with the underlying reference price. In this way, the perpetual contract mimics how margin trading markets work as buyers and sellers periodically exchange interest payments. The funding rate consists of 2 key parts: interest rate and premium index.
Every traded contract is comprised of the base currency and quote currency. The interest rate is a function of interest rates between the two currencies. The formula of the interest rate for perpetual contracts is as follows:
Interest Rate = (Interest Quote Index - Interest Base Index) / Funding Interval
- Interest Base Index is the interest rate for borrowing the base currency.
- Interest Quote Index is the interest rate for borrowing the quote currency.
- Funding Interval = 3, because there are three intervals for every 8 hours.
A premium index is used to adjust the next FR to the level that is consistent with where the perpetual contract is trading. The premium index formula is as follows:
Premium Index = (Max(0, Impact Bid Price - Mark Price) - Max(0, Mark Price - Impact Ask Price)) / Spot Price + Fair Basis used in Mark Price
Based on these calculations, here is the formula of the FR:
Funding Rate = Premium Index + clamp(Interest Rate - Premium Index, 0.05%, -0.05%)
The calculated FR is applied to a trader’s position value to define the amount that will be paid or received at the funding timestamp.
A perpetual contract has a range of benefits over other types of contracts, such as:
- No expiration date or immediate settlement.
- Trading is close to the underlying reference index price.
- Flexible leverage.
The spot price is determined through funding, which is derived from position value multiplied by the funding rate. The FR formula, in its turn, is based on the interest rate and premium index.