What are futures contracts?
A futures contract is an agreement to buy or sell a commodity, currency or instrument at a predetermined price at a specified time in the future.
Unlike the traditional spot market, in the futures market, transactions are not 'settled' immediately. Instead, the two counterparties will trade using a contract that specifies payment will take place at a future date. Additionally, futures markets do not allow users to directly buy or sell digital goods or assets. Instead, they are trading contracts that represent those things, and the actual asset (or cash) transaction will occur in the future - when the contract is fulfilled.
As a simple example, consider the case of a futures contract on a physical commodity such as wheat or gold. In some traditional futures markets, these contracts are established and, as a result, actual delivery takes place. Therefore, gold or wheat must have been stored and transported before. This creates additional costs (called shipping costs). However, many futures markets now have cash settlement regulations. This means that only the cash equivalent is paid (as there is no exchange of physical goods).
Additionally, the price of gold or wheat on the futures market can vary depending on the distance of the contract settlement date. The longer the time, the higher the actual cost will be. Additionally, the greater the uncertainty about future prices, the wider the price differential between the spot and futures markets.
Why do users trade using futures contracts?
Hedging and risk management: this is the main reason why futures contracts were invented.
Short selling: traders can make money from the price movement of an asset, even if they do not own the asset.
Leverage: traders can enter positions larger than their account balance. On Binance, perpetual futures can be traded with up to 20x leverage.
What are perpetual futures contracts?
Perpetual contracts are a special type of futures contract. Unlike the traditional form of futures contracts, perpetual contracts have no expiry date. So, a trader can hold a position for as long as he wants. Additionally, trading of perpetual contracts is based on Index Price. The Price Index consists of the average price of an asset across the major spot markets and their relative trading volumes.
Therefore, unlike regular futures contracts, perpetual contracts typically trade at or near the same price as the spot market. However, the biggest difference between traditional futures contracts and perpetual contracts is the 'settlement date' of the former.
What is Initial Margin?
Initial margin is the minimum value you must pay to open a leveraged position. For example, you can buy 100 BNB with an initial deposit of 100 BNB (at 10x leverage). So your initial margin will be 10% of the total order. The initial margin supports your leveraged position, it acts as collateral.
What is Maintenance Margin?
Maintenance margin is the minimum margin you must maintain to keep trading positions open. If your margin balance falls below this level, you will either receive a margin call (asking you to add more funds to your account) or accept the asset being liquidated. Most cryptocurrency exchanges will do the latter.
In other words, initial margin is the value you commit to when opening a position, and maintenance margin is the minimum balance you need to maintain to keep positions open. Maintenance margin is a dynamic value, it changes according to the market price and your account balance (collateral).
What is liquidation?
If the value of your collateral falls below the maintenance margin, your futures account may be liquidated. On Binance, liquidations occur in different ways, depending on each user's risk and leverage (based on their collateral and net risk exposure). The larger the total position, the higher the margin required.
Depending on the market and exchange, the liquidation mechanism is different. But with Binance, the exchange charges a nominal 0.5% fee for Level 1 liquidation (net spread less than 500,000 USDT). If the account has remaining funds after liquidation, the remainder will be returned to the user. If it has less, the user is declared bankrupt.
Note that when liquidating, you will have to pay additional fees. To avoid that, you can close your positions before reaching the liquidation price or add more money to your collateral balance - causing the liquidation price to move further away from the current market price .
What is Funding Rate?
Financing includes regular payments between buyer and seller, at applicable financing rates. When the funding rate is greater than 0 (positive), the trader who opens a Long position (buyer in the contract) must pay a fee on behalf of the trader who opens a Short position (seller in the contract). Conversely, a negative funding ratio means that the trader who opens a Short position pays this fee to the trader who opens a Long position.
The financing rate is calculated on two components: interest rate and premium. On the Binance futures market, the interest rate is fixed at 0.03% and the premium varies depending on the price difference between the futures market and the spot market. Binance does not charge fees for funding rate transfers as they take place directly between users.
So, when a perpetual futures contract is traded at a premium (higher than the spot market), Long positions have to pay Short positions due to the positive funding rate. That situation will push prices down, as long as traders close their long positions and new short positions are opened.
What is the reference price (Mark Price)?
The reference price is an estimate of the actual value of a contract (fair price) when compared with its actual transaction price (final price). Calculating a reference price helps prevent unfair liquidations - a phenomenon that can occur when the market is highly volatile.
Therefore, while the Price Index refers to the price of the spot market, the reference price represents the fair value of the perpetual futures contract. On Binance, the reference price is based on the Price Index and funding rate, and it is also an essential part of the “unrealized PnL” calculation.
What is PnL?
PnL (Profit and loss ratio) stands for profit and loss, and it can be in a realized or unrealized state. When you have open positions in the perpetual futures market, your PnL is unrealized - meaning it is still changing with market movements. When you close your positions, unrealized PnL becomes (partially or fully) realized PnL.
Because realized PnL is the profit or loss derived from closed positions, it has no direct relationship to the reference price, but only to the executed price of the orders. On the other hand, PnL has not made continuous changes and was the main driver for the liquidation. Therefore, reference prices are used to ensure that the unrealized PnL calculation is accurate and fair.
What is an insurance fund?
Simply put, the Insurance Fund is what prevents losing traders' balances from falling below zero, while also ensuring that winning traders get their profits.
To illustrate, let's assume that Alice has $2,000 in her Binance futures account. This amount is used to open a long position of 10x BNB at $20 per cryptocurrency. Note that Alice is buying the contract from another trader rather than Binance. So on the other side of the trade we have Bob, with a short position of the same size.
Due to the use of 10x leverage, Alice now holds a position of 1,000 BNB (worth $20,000), with $2,000 in collateral. However, if the BNB price drops from $20 to $18, Alice's position may close automatically. This means her assets will be liquidated and her $2,000 mortgage is completely forfeit.
If for any reason the system cannot close the positions on time and the market price falls further, the Insurance Fund will be activated to cover the losses until the position is closed. This won't change much for Alice, since her assets have been liquidated and her balance is zero, but it ensures that Bob can collect his profits. Without the Insurance Fund, Alice's balance would not only decrease from $2,000 to zero, but could also become negative.
However, in reality, her long position would probably be closed before then because her sustained margin would be below the required minimum. The liquidation fee goes directly to the Insurance Fund and any remaining funds are returned to the user.
So, the Insurance Fund is a mechanism designed to use collateral taken from the assets of liquidated traders to cover losses on bankrupt accounts. Under normal market conditions, the Insurance Fund will usually increase continuously as user assets are liquidated.
In short, the Insurance Fund gets bigger the more users are liquidated before their position reaches a breakeven or negative value. But in more severe cases, the system may not close all positions and the Insurance Fund will be used to cover possible losses. Although this is not common, it can occur during periods of high volatility or low market liquidity.
What is auto cancel?
Auto-deleveraging is a method of liquidating a counterparty that only takes place if the Insurance Fund ceases operations (in specific situations). Although this is not likely to happen, such an event would require profitable traders to contribute a portion of their profits to cover the losses of losing traders. Unfortunately, with the high volatility of the cryptocurrency market and the high level of leverage, this phenomenon cannot be completely avoided.
In other words, counterparty liquidation is the final step taken when the Insurance Fund cannot cover all the bankrupt positions. Typically, the positions with the highest profits (and leverage) will be the ones that contribute the most. Binance uses an indicator that tells users where they are in the auto-cancel queue.
On the Binance futures market, the system takes every possible step to avoid auto-cancellation, and Binance has several features to minimize its impact. If that happens, the liquidation of the partnership will be done without any market fees. Notifications will also be sent immediately to affected traders. Users are then free to re-enter positions at any time.