What is a futures contract?
A futures contract is an agreement to buy or sell a commodity, currency, or other financial asset at a predetermined price at a specific time in the future.
Unlike traditional spot markets, transactions in contract markets are not settled immediately. Buyers and sellers trade contracts that provide for settlement at a certain time in the future. In addition, users cannot directly buy or sell physical commodities or digital assets in the contract market. Instead, they trade contracts representing those assets, and the actual transaction of the assets (or cash) will occur in the future, when the contracts are executed.
Let’s take futures contracts of physical commodities such as wheat and gold as examples. In some traditional contract markets, delivering these contracts means delivering the physical commodity. Therefore, the gold or wheat must be properly stored and transported, which in turn incurs additional costs (called "storage costs"). However, many contract markets now support cash settlement, which means only settlement of equivalent cash value (no physical exchange).
In addition, the price of gold or wheat in the contract market may vary depending on the distance of the contract settlement date. The further the expiration date is, the higher the corresponding storage cost will be, the uncertainty of the price will also increase, and the greater the potential price difference between the futures market and the spot market.
Why trade futures contracts?
Hedging and risk management: This is the main reason for the creation of futures contracts.
Short-term exposure: Traders can bet on the performance of an asset even if they do not own it.
Leverage: Traders can open positions that are larger than their account balance.
What is a perpetual futures contract?
A perpetual contract is a special type of futures contract. Unlike traditional contracts, perpetual contracts have no expiration date and users can choose to hold positions forever. In addition, perpetual contract trading is based on the underlying index price. It consists of the average price of an asset, influenced by major spot markets and relative trading volumes.
Unlike traditional contracts, the trading price of perpetual contracts is usually the same as or very close to the spot market. However, the biggest difference between traditional contracts and perpetual contracts is that the former stipulates a "settlement date".
What is initial margin?
Initial margin is the minimum margin required when opening a leveraged position. For example, if the initial margin is 100 BNB, the user can buy 1,000 BNB with 10x leverage. Therefore, the initial deposit is 10% of the total order amount. Initial margin is a strong support for leveraged positions and plays the role of collateral.
What is maintenance margin?
Maintenance margin is the minimum collateral required to maintain the corresponding trading position. If the margin balance is lower than the maintenance margin, the user will receive a margin call notice (requiring them to fund their account) or be directly forced to liquidate. Most digital currency trading platforms choose the latter approach.
In other words, initial margin is the amount committed when opening a position, while maintenance margin refers to the minimum balance required to maintain a position. Maintenance margin changes dynamically, depending on market prices and account balance (collateral).
What is forced liquidation?
If the collateral is lower than the maintenance margin, your contract account will be forced to be liquidated. Binance forces liquidation in different ways based on each user’s risk and leverage (collateral and net exposure). The larger the total position, the higher the proportion of margin required.
This mechanism varies by market and trading platform, but Binance charges a nominal fee of 0.5% for level 1 liquidations (net exposure below 500,000 USDT). After forced liquidation and payment of nominal fees, the remaining funds in the account will be returned to the user. If the balance is less than 0.5%, the account will be reset to zero.
Please note that after forced liquidation, users will need to pay additional fees. To avoid this, you can close the position yourself before the liquidation price is reached, or fund your margin balance to increase the gap between the liquidation price and the current market price.
What is the funding rate?
Funding consists of periodic payments between the buyer and seller, depending on current funding rates. If the funding rate is greater than zero (positive value), longs (contract buyers) pay shorts (contract sellers) a funding rate. In turn, shorts pay a funding rate to longs.
Funding rates are made up of two components: interest rate and premium. The interest rate in the Binance futures market is fixed at 0.03%, while the premium index changes based on the price difference between the contract market and the spot market. Funding Rate Transfers are completed directly between users, and Binance does not charge any fees.
When a perpetual futures contract trades at a premium (price is higher than the spot market), the funding rate is positive and longs pay the funding rate to shorts. This is expected to drive prices lower as long positions are liquidated and new short positions are opened.
What is a marked price?
The mark price is an estimate of a contract's true value (fair price) compared to the actual transaction price (last price). Calculating the mark price can effectively avoid unfair liquidation during severe market fluctuations.
Therefore, while the index price is related to the spot market price, the mark price represents the fair value of the perpetual futures contract. For Binance, the mark price is based on the index price and funding rate and is an important factor in calculating "unrealized profit and loss."
How to calculate profit and loss (PnL)?
PnL stands for profit and loss, which can be divided into realized profit and loss and unrealized profit and loss. If you hold an open position in the perpetual contract market, profits and losses have not yet been realized and will change with market developments. After closing the position, unrealized profits and losses will be converted into realized profits and losses.
Realized profit or loss is the profit or loss derived from a closed position. It is not directly related to the mark price, but is only related to the execution price of the order. Unrealized P&L, on the other hand, is constantly changing and is the main driver of liquidation. Mark prices are therefore used to ensure that calculated unrealized profits and losses are accurate, credible and fair.
What is a protection fund?
In short, a protection fund effectively prevents losing traders from having their balances fall into negative territory while ensuring that profitable traders receive their profits.
For example, let’s say Alice has $2,000 in her Binance Futures account. With this funding, she established a 10x long position in BNB at a unit price of $20. Please note that the contract Alice purchased did not originate from Binance, but was provided by another trader. As the counterparty, Bob also has a short position of the same size.
Driven by 10x leverage, Alice now has a position size of 100 BNB (worth $20,000) with a collateral of $2,000. However, if the price of BNB drops from $20 to $18, Alice may face automatic liquidation. This means that her assets will be forced to liquidate, and her $2,000 deposit will be lost.
If the system cannot close the position in time for some reason and the market price drops further, the protection fund will be activated to make up for the relevant losses until the position is closed. Alice won't see much change here, because her balance will return to zero after the forced liquidation, but this will ensure that Bob gets corresponding benefits. Without a protection fund, Alice's $2,000 would not only be lost, but her account balance would even become negative.
However, in actual trading, her maintenance margin will be below the minimum requirement and her long position may have been closed before then. The forced liquidation fee is paid directly by the protection fund, and the remaining funds are returned to the user.
Therefore, the protection fund mechanism aims to effectively utilize the deposits paid by traders whose positions were forced to be liquidated to make up for the losses of zeroed accounts. Under normal market conditions, the protection fund is expected to continue to grow as users are forced to liquidate their positions.
To sum up, when a user's position is forced to be liquidated before it reaches breakeven or becomes negative, the protection fund will increase. In more extreme cases, the system may not be able to close all positions, in which case the protection fund will be used to cover potential losses. This situation is uncommon, but it can happen during times of severe market volatility or extreme lack of liquidity.
What is automatic deleveraging?
Automatic deleveraging is a way for counterparties to force liquidation of positions. Automatic position reduction will only occur if the protection fund fails (certain circumstances arise). Although the probability of occurrence is extremely low, such events require profitable traders to use part of their profits to cover the losses of losing traders. Unfortunately, the digital currency market is highly volatile and the leverage provided by perpetual contracts is relatively high. Automatic position reduction cannot be completely avoided, but we will make every effort to reduce this probability.
In other words, counterparty liquidation is the last resort when the protection fund is unable to cover all zeroed positions. Generally speaking, the positions with the highest profits (and leverage) also contribute the largest proportion to the auto-deleverage. Binance uses an indicator to inform users of their position in the auto-deleveraging queue.
Binance’s futures market system takes all necessary measures to avoid automatic deleveraging and minimizes its impact through multiple features. If automatic deleveraging does occur, counterparty liquidation will be performed at zero market fees. Affected users will be notified immediately and can re-enter the market at any time.