A futures contract is an agreement to buy or sell a commodity, currency, or other asset at a predetermined price at a specified time in the future.
Unlike traditional spot markets, where trades are settled immediately, futures trading involves two counterparties entering a contract that defines settlement at a future date. In futures markets, users don’t directly trade physical goods or digital assets—they trade contractual representations of those assets. The actual exchange of the asset (or cash) happens later when the contract is executed.
A simple example involves futures for physical commodities like wheat or gold. In some traditional futures markets, these contracts are physically delivered, meaning the actual goods must be transferred. This involves storage and transportation costs—known as carry costs. Today, however, most futures markets are cash-settled. Only the cash equivalent changes hands, with no physical exchange of goods.
Prices in futures markets for assets like gold or wheat can vary based on the contract’s expiration date. The longer the time gap, the higher the carry costs and future price uncertainty—potentially widening the gap between spot and futures prices.
Core Features of Futures Contracts
- Hedging and risk management: This is one of the original purposes of futures.
- Short exposure: Traders can speculate on asset performance without holding the asset.
- Leverage: Traders can control positions larger than their account balance.
Understanding Perpetual Futures
Perpetual futures share the inherent nature of standard futures but, unlike traditional contracts, they have no expiration date. This means positions can be held open indefinitely. Additionally, perpetual futures trading is based on an underlying index price. This index reflects the average asset price across major spot markets, weighted by trading volume.
As a result, perpetual contracts often trade at or very near spot market prices—unlike traditional futures. But the biggest difference lies in the settlement mechanism.
Initial Margin and Maintenance Margin
The initial margin is the minimum amount required to open a leveraged position. For example, with an initial margin of 100 BNB and 10x leverage, a user can buy 1,000 BNB worth of contracts. In short, the initial margin acts as collateral, supporting the leveraged position.
The maintenance margin is the minimum amount of collateral that must be maintained to keep a position open. If the margin balance falls below this level, the trader may face a margin call or liquidation. Most crypto exchanges opt for automatic liquidation.
In other words, the initial margin is what you commit to open a position; the maintenance margin is the minimum balance you must hold to keep it open. The maintenance margin is a dynamic value that changes with market conditions and account equity.
Liquidation Explained
If the value of the collateral falls below the maintenance margin, the futures account may be liquidated. The exact liquidation mechanism varies by exchange and user risk level, often depending on total exposure and leverage used. Larger positions require higher margins.
While procedures differ across platforms, some exchanges charge a nominal fee for liquidation. If surplus funds remain after liquidation, they are returned to the user. If not, the account is declared bankrupt.
Note that liquidation often incurs additional fees. To avoid this, close positions before reaching the liquidation price, or add more collateral to move the liquidation price further from the current market rate.
Funding Rates in Perpetual Futures
Funding consists of periodic payments between buyers and sellers based on the current funding rate. If the funding rate is positive, traders holding long positions (buyers) pay those holding short positions (sellers). A negative funding rate means shorts pay longs.
The funding rate typically combines a fixed interest rate and a premium component based on the price difference between the perpetual futures and spot markets. Some platforms facilitate direct user-to-user funding rate payments with no extra fees.
When perpetual futures trade at a premium compared to the spot market, the funding rate turns positive. Longs pay shorts, encouraging longs to close and new shorts to open—which may push prices down.
Mark Price and Its Importance
The mark price estimates the fair value of a contract, as opposed to the last traded price. It helps prevent unfair liquidations during highly volatile or illiquid market conditions.
While the index price relates to spot market prices, the mark price reflects the fair value of perpetual futures contracts. It is also essential for calculating unrealized profit and loss (PnL).
Profit, Loss, and Mark Price
PnL stands for profit and loss and can be either realized or unrealized. In perpetual futures markets, open positions have unrealized PnL, which fluctuates with market moves. When a position is closed, unrealized PnL becomes realized.
Realized PnL refers to the actual gain or loss from closed positions and depends only on the execution price. Unrealized PnL is always changing and is a key factor in liquidation risk. The mark price ensures that unrealized PnL is calculated fairly and accurately.
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Insurance Fund Mechanism
In short, the insurance fund ensures that losing traders’ balances don’t fall below zero while guaranteeing that winning traders receive their profits.
For example, suppose Alice has $2,000 in her futures account and uses it to open a 10x long position on BNB at $20 per coin. Note that Alice buys the contract from another trader—say, Bob, who holds a short position of the same size.
With 10x leverage, Alice holds a position worth $20,000 (100 BNB) with only $2,000 in collateral. If the BNB price drops from $20 to $18, her position could be liquidated, meaning she loses her entire $2,000 collateral.
If the system fails to close her position in time and the market drops further, the insurance fund covers the loss until the position is settled. Although Alice is already liquidated, Bob is guaranteed his profit. Without the insurance fund, Alice’s balance could turn negative.
In practice, however, Alice’s long position would be closed once it falls below the maintenance margin. Liquidation fees are paid into the insurance fund, and any remaining collateral is returned.
Thus, the insurance fund is designed to cover losses from bankrupt accounts using collateral from liquidated traders. In normal market conditions, the insurance fund is expected to grow over time.
To summarize, the insurance fund grows when positions are liquidated before reaching negative equity. In extreme cases, such as during high volatility or low liquidity, the fund may be used to cover potential losses.
Auto-Deleveraging (ADL)
Auto-deleveraging is a counterparty liquidation method used only in specific situations when the insurance fund is insufficient. Although rare, if such an event occurs, profitable traders may need to contribute part of their gains to cover the losses of losing traders. Unfortunately, due to crypto market volatility and high leverage offered to users, this risk cannot be entirely eliminated.
In other words, ADL is a last-resort measure. Usually, the most profitable (and highly leveraged) positions contribute first. Some exchanges provide indicators showing a user’s place in the ADL queue.
Many trading platforms take measures to avoid auto-deleveraging and include features to minimize its impact. If ADL occurs, counterparty liquidation is fee-free, and affected traders are notified immediately. Users can re-enter positions at any time.
Frequently Asked Questions
What is the main difference between perpetual and traditional futures?
Perpetual futures have no expiration date, allowing traders to hold positions indefinitely. They also use a funding rate mechanism to keep the contract price aligned with the spot market, unlike traditional futures, which have fixed settlement dates.
How does leverage work in perpetual futures trading?
Leverage allows traders to open positions larger than their account balance. For example, 10x leverage lets you control a $10,000 position with $1,000 of collateral. However, higher leverage also increases liquidation risk.
What happens during liquidation?
If your collateral value falls below the maintenance margin requirement, your position may be automatically closed. Liquidation often involves fees, and any remaining collateral is returned after deducting costs and losses.
Can funding rates be negative?
Yes. A negative funding rate means short position holders pay long position holders. This typically occurs when perpetual futures trade at a discount to the spot price.
How is the mark price calculated?
The mark price is a weighted average of prices from major spot markets. It helps prevent unfair liquidations by providing a fair value estimate for perpetual futures contracts, distinct from the last traded price.
Is auto-deleveraging common?
No, auto-deleveraging is rare and occurs only in extreme market conditions when the insurance fund cannot cover all losses. Exceptions include periods of exceptionally high volatility or illiquidity.