In the dynamic of financial markets, there are various instruments cater to the needs of diverse investors and traders. There are two such instruments, that often spark interest and confusion from futures contracts. While both are derivative instruments, and are therefore used for speculative and hedging purposes, they possess distinct characteristics that differentiates them. In this article, we will see the differences between traditional futures contracts and their perpetual counterparts, shedding light on their unique features, trading mechanisms, and potential advantages as well as drawbacks.
- Understanding Futures Contracts
- Expiration Date
- Settlement Mechanism
- Understanding Perpetual Futures Contracts
- No Expiration:
- Funding Mechanism
- Leverage and Margin
- Market Price and Premiums/Discounts
Understanding Futures Contracts
Futures contracts are standardised agreements that are financial in nature, and hence obligate partes to buy and sell an asset at a predetermined price in future date. Such contracts can be based on the various underlying assets, including commodities, stocks, indices, and currencies. Future contracts play a crucial role in role in risk management, allowing participants to hedge against price fluctuations and providing some speculative opportunities for traders.
Expiration Date
- Futures Contracts
One fundamental characteristic of traditional futures contracts is their fixed expiration date. This predetermined date signifies when the contract must be settled, and the underlying asset must be delivered on cash.
- Perpetual Futures Contracts
In contrast, perpetual futures contracts do not have a fixed expiration date. They are designed to mimic the perpetual nature of spot markets, allowing the traders to hold positions indefinitely if they want to but meeting the funding requirements in the meantime.
Settlement Mechanism
- Futures Contracts
Traditional futures contracts typically involve physical delivery of underlying asset upon expiration. However, many traders now opt for cash settlement of where the difference between the contract price and the market price at expiration is paid in cash.
- Perpetual Futures Contracts
In perpetual futures contracts, cash settlement is present and based on periodic basis rather than having a fixed settlement date. Traders are required to pay and receive funding rates on the prevailing market conditions at regular intervals.
Understanding Perpetual Futures Contracts
Perpetual futures contracts, often referred to as “perpetual swaps” were introduced to address certain limitations of traditional future contracts. These kinds of perpetual instruments are commonly found in cryptocurrency exchanges, providing an alternative to spot trading and traditional futures markets.
No Expiration:
Futures Contracts
Traditional futures contracts, have a specific and fixed expiration date, creating a need to roll over positions and exiting contracts before their expiration date.
Perpetual Futures Contracts
The absence of an expiration date in perpetual contracts eliminates the need for regular contract rollovers. Traders can hence maintain their positions without worrying about contract expiration, making perpetual contracts a convenient choice for those seeking to continue exposure towards the underlying asset.
Funding Mechanism
Futures Contracts
In traditional futures contracts, the funding rate mechanism is primarily based on the difference between spot price at the settlement time.
Perpetual Futures Contracts
In terms of perpetual futures contracts, a funding mechanism is instituted to make the price of the contracts aligned with the underlying asset present in the spot market. Funding rate is exchanged between long and short positions at predetermined intervals, encouraging convergence between the contract price and spot price.
Leverage and Margin
Futures Contracts
Leverage in traditional future contracts, are determined by the initial margin requirements set by exchange. Traders can amplify such exposures to the underlying asset by depositing a fraction of the contract value as margin.
Perpetual Futures Contracts
Perpetual Futures contracts also provide leverage, but the funding mechanism adds a layer of complexity. Traders can consider giving funding rate, which can be cost effective, and suitable to market conditions. High leverage, combined with the perpetual nature of these contracts can result in significant profits and losses.
Market Price and Premiums/Discounts
Futures Contracts
Price of traditional futures contracts may deviate from the spot price, leading to a premium or a discount. This can be further influenced by factors such as interest rates, dividends, and storage costs.
Perpetual Futures Contracts
Perpetual Futures contracts are made in accordance with spot prices of the asset, and thus minimise the premium and discount compared to the traditional futures contracts. The funding mechanism helps in maintaining this alignment over time.
Advantages and Disadvantages
Perpetual Futures Contracts
Continuous Exposure
Perpetual Futures contracts allow traders to maintain continuous exposure to the underlying asset without the need for regular contract rollovers.
Liquidity
Due to their popularity, perpetual contracts, often exhibit high liquidity, providing traders with an ability to enter and exit positions.
Flexibility
Perpetual nature and funding mechanisms make such products flexible, attracting traders with varying strategies.
Drawbacks of Perpetual Futures Contracts
Funding Costs
Traders include factors such as funding costs which can be a consideration for long term positions and impact the overall profitability.
Complexity
The funding rate mechanism and periodic settlements, can add a complexity for traders unfamiliar with the perpetual contracts, potentially leading to the unexpected costs.
Advantages of Traditional Futures Contracts
Clear Expiration
The fixed expiration date in traditional futures contracts provides clarity for traders, facilitating easier planning and risk management.
Simplicity
The absence of a funding mechanism simplifies the trading process, especially for those who prefer to have a straightforward approach.
Drawbacks of Traditional Futures Contracts
Rolling Costs
Traders in traditional futures contracts face rolling costs as they approach the contract’s expiry date and that can corrode the profitability margin.
Lesser Flexibility
A fixated expiry date, limits the flexibility of traditional futures contracts, requiring a proactive management to avoid complications.
Conclusion
In the overall changing landscape of financial markets, both futures and perpetual contracts serve a distinct purpose, and cater to the diverse needs of the traders and investors. Understanding the intricate nuances of both instruments can help many of the beginners and advanced learners to seek their trading journeys with precaution. Ultimately, the choice between such derivatives depends strongly on the preferences, risk tolerances, and particular goals of market participants.
About BITFLEX
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