What Are Futures Contracts
a futures contract is an agreement to buy or sell an asset at a specific price and date in the future for instance Alice and Bob can create a contract where they commit to trade one Bitcoin for $10,000 at the end of the year so if Alice’s on the buying side Bob must sell one Bitcoin to her at the settlement date for that specific price this means that if Bitcoin is trading above ten thousand dollars by the end of the year Alice will pay less than the actual market value so Bob loses money and Alice makes a profit but if Bitcoin is below ten thousand dollars at the settlement date Bob profits and Alice loses in this example they would only trade bitcoins at the settlement date in most cases though they don’t really trade bitcoins but only the equivalent value in cash this is what we call a cash settlement note that the settlement date is defined when the contract is created it can’t be changed still Alice and Bob can buy and sell futures contracts multiple times before they expire and the price of each contract varies according to the market supply and demand so Alice can buy one contract for ten thousand dollars and another one for ten thousand five hundred dollars she could then hold these contracts until the settlement date or sell them to someone else for a shorter term profit futures contracts are derivatives which means their market price is derived from an underlying instrument so unlike traditional spot markets
you don’t really trade assets only contracts that represent them as such the exchange of contracts can happen several times prior to the settlement date but the actual settlement happens only once for each contract after they expire but did you know there’s a
What Are Perpetual Futures Contracts
special type of futures contracts that simply don’t have a settlement date these are the ones we call perpetual futures contracts with perpetual futures contracts Alice can hold the position for as long as she wants given the minimum requirements are met there are three central concepts at the core of perpetual futures initial and maintenance margin liquidation and insurance fund let’s take an example of Example of Perpetual Futures Contracts perpetual futures trading to understand these concepts suppose
Alice has 100 BnB and she uses them to buy 1,000 B&B at 10x leverage in this case the 100 B&B acts as collateral and is what backs her position this is what we call the initial margin but after opening a position Alice wants to make sure her position stays open and that’s where the maintenance margin comes in the maintenance margin is a dynamic value that changes according to the assets market price and to the total balance of her margin account summing up the initial margin is the amount Alice commits when opening a leveraged position and the maintenance margin is the minimum value required for her to keep all positions open in this case only one so if Alice’s balance drops below the maintenance margin level she will either receive a margin call or be liquidated if Alice receives a margin call she’ll be asked to increase the collateral by adding more funds to her account but margin calls aren’t common in the cryptocurrency space in fact most exchanges rely solely on a liquidation mechanism in short liquidation is the forced closing of leveraged positions it may occur when the total value of a market account falls below the maintenance margin meaning that the collateral is too low in some cases open positions will be closed and all holdings will be liquidated leaving the account with zero balance in other cases a trader may experience a partial liquidation which involves the reduction of open positions in the liquidation of some of their assets still each trading platform has a unique system for perpetual futures contracts so the liquidation mechanisms vary from one exchange to another along with liquidation the insurance fund is another important concept of perpetual futures markets simply put the insurance fund is what prevents the balance of losing traders to drop below zero it also guarantees the winning traders get their profits to illustrate let’s suppose Alice has $2,000 in her Bonin’s futures account she uses her entire balance to open a 10x BnB long position paying $20 per contract note that she is buying contracts from another trader and not from by Nance so let’s assume Bob is on the other side of the trade with a short position of the same size because of the leverage
Alice now holds a 1000 BnB position valued at $20,000 however if the B&B price drops from $20 to $18 and this could be liquidated in that case all her open positions would be closed and her $2,000 collateral entirely lost but let’s imagine that for whatever reason the system isn’t able to close Alice’s positions on time and the market drops even more that’s where the Insurance Fund comes in play the Insurance Fund protects the system against unpredictable and abnormal market conditions in this case it’s activated to cover the losses generated by Alice’s positions which couldn’t be closed on time so the system had to pay extra money to finally close her positions this doesn’t change much for Alice because she was liquidated and her balance is now zero but it ensures that Bob is able to get his deserved profit without the insurance fund Alice’s balance wouldn’t only dropped from two thousand dollars to zero but could also become negative a negative balance could lead to at least two undesired outcomes 1 Alice would be asked to add more funds to pay her debt or to part of Bob’s profit would be used to cover Alice’s negative balance so the Insurance Fund is a mechanism designed to prevent those situations it uses the collateral taken from liquidated traders to ensure that users don’t get negative balances to learn more about economics blockchain and cryptocurrencies check out our other videos at finance academy