In the world of cryptocurrencies, and financial investments, traders seek tools and instruments that allow them to profit from price movements of multiple assets. Futures and perpetual swap contracts have therefore gained immense popularity in recent years. Such derivative contracts offer traders an opportunity to speculate and foreboding on the price of assets and not own them in real life. This article will focus on futures and perpetual swaps contracts, exploring what they are made of and what their key differences are.
Understanding Future Contracts
Future contracts are financial derivatives obliging the parties involved in them to buy and sell a particular quantity of an underlying asset at a predetermined price on a future date. Such contracts are traded on organized exchanges, and they serve many purposes including hedging and speculation.
Some Key Features of Futures Contracts
Standardization:
Futures contracts are highly standardized and hence specify the quantity and quality of an underlying asset, its delivery date, and location. Such standardization makes futures contracts easily tradable on various exchanges.
Clearinghouses
A clearing house acts as an intermediary between the two parties in a futures contract. It ensures the integrity of the contract by guaranteeing the performance of both parties.
Margin Requirements
Traders are required to deposit an initial margin and maintain a maintenance margin to make the contract workable. Such margin requirements play a role as collateral to cover potential loss.
Cash Settlement vs. Delivery
Cash settlement in futures contracts results in physical delivery of the underlying asset and most are settled in cash, where the difference between the contract price and market price is exchanged.
Advantages Associated with Futures Contracts
Hedging
Futures contracts provide an effective means to hedge against price fluctuations. Producers and consumers of these commodities often use futures to lock in prices and minimize the exposure to market volatility.
Liquidity
Such contracts are highly liquid and can be easily bought or sold on organized exchanges.
Leverage
Futures contracts also allow many traders to control large positions with a small amount of capital, thanks to available margin requirements.
Understanding Perpetual Swaps Contracts
Perpetual swap contracts, also called perpetual futures contracts, are new in addition to the world of derivatives. They share some similarities with traditional futures contracts but also come with some key differences:
Prominent Key Features of Perpetual Swaps Contracts
No Expiry Date
Contrary to futures contracts, perpetual swaps do not carry an expiration date. They can be held indefinitely if the trader meets the margin requirements.
Funding Rate
Perpetual swaps feature a funding rate mechanism that helps to keep the contract price aligned with the spot price of the asset. The funding rate is paid periodically from one group to another depending on the contract’s price relative to the underlying asset’s price.
Margin and Leverage
Like futures, perpetual swaps also require traders to deposit an initial margin and maintain some maintenance margin too. This facilitates traders to leverage their positions.
Settlement Mechanism
Perpetual swaps are settled in crypto, usually BTC rather than in cash or underlying assets.
Differences Between Futures Contracts and Perpetual Swap Contracts
Expire vs. No Expiry Date
The most important difference between the futures contracts is having a fixed expiry date, while perpetual swaps do not expire, allowing traders to maintain their positions indefinitely.
Funding Rates vs. Settlement Prices
Perpetual swaps use a funding rate to maintain price alignment with the underlying asset, whereas futures contracts rely on settlement prices determined upon expiry.
Settlement Currency
Futures contracts are mostly settled in cash or physical delivery of the underlying asset. But in the case of perpetual swaps, they are settled in base currency or cryptocurrency present in the form of stablecoins.
Liquidity and Availability
Perpetual swaps are typically available to trade 24/7 and tend to have higher liquidity, especially for cryptocurrencies as compared to futures contracts.
Risk Management
As both instruments can be used to assess risk management, futures contracts are often preferred to hedge physical assets due to their fixed expiry dates and settlement options.
Conclusion
Futures and perpetual swaps contracts are powerful financial instrument that provides traders with multiple opportunities for speculation and risk management. Each has its unique opportunities and advantages, making them a suitable option for different trading strategies and preferences. Understanding key differences helps to eliminate trading mistakes and avoid future losses. As the financial landscape continues to evolve futures and perpetual swaps are likely to remain an integral tool for those seeking exposure to a wide range of assets and commodities.
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