What is a futures contract?
A futures contract is an agreement to buy and sell a commodity, currency, or other instrument at a predetermined price at a specific time in the future.
In contrast to the traditional spot market, in the futures market, trades are not ‘settled’ immediately. Two parties will trade a contract, which determines future settlement. Futures markets also do not allow users to buy or sell commodities/digital assets directly, but they trade a contract representing that commodity/digital asset, and the actual trading of the asset (or cash) will occur in the future - when the contract is executed.
As a simple example, imagine a futures contract on a physical commodity, such as wheat or gold. In some traditional futures markets, these contracts are prepared for delivery. This means that there is physical delivery of the commodity. As a result, the gold or grain had to be stored and shipped, giving rise to additional costs (referred to as freight costs). However, most futures markets now have cash settlement. This means that only cash equivalents are settled (there is no physical exchange of the goods).
Additionally, the price of gold or wheat in the futures market may differ depending on how far away the contract settlement date is. If the price difference is greater, the transportation costs will be higher, the uncertainty of potential prices in the future will be higher. and the potential for price differences between the spot and futures markets is getting bigger.
Why do users trade futures contracts?
Risk mitigation and management: this is the main reason why the futures market was created.
Short-term exposure: traders can bet against an asset's performance even if they don't own the asset.
Leverage: traders can enter positions larger than their account balance.
What is a perpetual futures contract?
A perpetual contract is a special type of futures contract. Unlike traditional futures contracts, this type has no expiration date. So a person can stay in one position as long as he wants. Additionally, perpetual contract trading is based on the underlying Index Price. This Price Index consists of the average price of an asset, according to the majority of spot markets and its relative trading volume.
Thus, unlike conventional futures, perpetual contracts often trade at the same or very similar prices to the spot market. However, under extreme market conditions, the mark price may deviate from the spot market price. However, the biggest difference between traditional futures and perpetual contracts is the ‘settlement date’ of traditional futures.
What is initial margin?
Initial margin is the minimum amount that must be paid to open a leveraged position. For example, you can buy 1,000 BNB with an initial margin of 100 BNB (10x leverage). So, your initial margin is 10% of the total order. Initial margin supports your leveraged position by serving as collateral.
What is minimum margin?
Minimum margin is the minimum amount of collateral that must be deposited to keep a trading position open. If your margin balance falls below this level, there are two possibilities, you will receive a margin call (asking you to add funds to your account) or be liquidated. Most cryptocurrency exchanges will do the latter.
In other words, initial margin is the value you set when opening a position, and minimum margin refers to the minimum balance you need to keep a position open. The minimum margin is a dynamic value that can change according to market prices and your account (collateral) balance.
What is liquidation?
If the value of your collateral falls below the minimum margin, the futures account may undergo liquidation. Depending on the exchange used, liquidation can occur in various ways. Generally, the liquidation price changes according to each user's risk and leverage (based on collateral and net exposure). The larger their total position, the higher the margin required.
To avoid liquidation, you can close the position before the liquidation price is reached or add more funds to the collateral balance so that the liquidation price moves away from the current market price.
What is funding rate?
Funding consists of regular payments between buyers and sellers based on current funding rates. If the funding rate is above zero (positive), traders who choose long positions (contract buyers) must pay traders who choose short positions (contract sellers). Conversely, a negative funding rate means that short positions pay long positions.
Funding rates are based on two components: interest rate and premium. Interest rates can change from one exchange to another, while premiums vary based on price differences between the futures and spot markets.
Generally, when a perpetual futures contract trades at a premium (higher than the spot market), the long position must pay the short position because of the positive funding rate. This situation is expected to reduce prices, because long positions are closed and short positions are opened.
What is mark price?
Mark price is an estimate of the true value of a contract (fair price) when compared to the actual trading price (last price). Mark price calculations prevent unfair liquidations that can occur when markets are highly volatile. While the Index Price is related to the spot market price, the mark price represents the fair market value of the perpetual futures. Typically, the mark price is based on the Index Price and funding rates. The mark price is an important part of the “unrealized PnL” calculation.
What is PnL?
PnL stands for profit and loss, and this can be realized or unrealized. When you open a position in a futures contract market, your PnL is not realized, meaning the number can still change in response to market movements. When you close a position, the unrealized PnL becomes the realized PnL (either partially or completely).
Since realized PnL is the profit or loss resulting from closed positions, its direct relationship is not with the mark price, but with the price of the executed order. On the other hand, unrealized PnL is constantly changing and is the main driver for liquidation. In this way, the mark price is used to ensure that the unrealized PnL calculation is accurate and fair.
What is Insurance Fund?
Simply put, the Insurance Fund prevents losing traders' balances from falling below zero, while ensuring that winning traders make a profit.
For example, imagine Alice has $2,000 in a futures account that is used to open a 10x long BNB position at $20 per coin. Note that Alice bought the contract from another trader, not from an exchange. So, on the other side of the trade, there is Bob with a short position of the same size.
Because of the 10x leverage, Alice now has a position of 100 BNB (worth $20,000) with collateral of $2,000. However, if the price of BNB falls from $20 to $18, Alice's position will be closed automatically. This means his assets will be liquidated and his $2,000 security deposit will be completely forfeited.
If for any reason, the system cannot close the position on time and the market price falls further, the Insurance Fund will be activated to cover losses until the position is closed. This will not affect Alice's position, since she has already been liquidated and her balance has already reached zero, but it guarantees that Bob can receive his profit. Without the Insurance Fund, Alice's balance would not only fall from $2,000 to zero, it could also go negative.
However, in reality, her long position will probably be closed before that point because Alice's minimum margin will be lower than the minimum required. Liquidation costs will go directly to the Insurance Fund and any remaining funds will be returned to the user. So, the Insurance Fund is a mechanism designed to use collateral collected from liquidated traders to cover losses from bankrupt accounts. Under normal market conditions, the Insurance Fund is expected to continue to grow as users are liquidated.
In conclusion, the Insurance Fund will get bigger when users are liquidated before their position reaches the break-even point or negative value. However, in more extreme cases, the system may not be able to cover all positions and the Insurance Fund will be used to cover potential losses. Although not common, this can occur during periods of high volatility or low market liquidity.
What is Auto-deleveraging?
Auto-deleveraging is a method of liquidation of counterparties that only occurs if the Insurance Fund ceases to function (in certain situations). Although unlikely, such an event would require profitable traders to contribute a portion of their profits to cover the losses of losing traders. However, due to the volatility that exists in the cryptocurrency market, this event is impossible to avoid completely.
In other words, liquidation of counterparties is the last step taken when the Insurance Fund cannot cover all insolvent positions. Typically, the position with the highest profit (and leverage) will contribute more. Trading systems will usually take all possible steps to avoid auto-deleveraging. However, this differs from one exchange to another.