How to profit from market volatility using linear and inverse contracts

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Key points to remember

  • A perpetual contract is a derivative of cryptocurrency that does not expire in time. Traders can hold a position indefinitely and close the position at any time.
  • The funding rate is paid between the holders of long and short positions. When the funding rate is positive, longs pay shorts and when negative, shorts pay longs.
  • Traders can engage in linear and inverse contracts depending on the currency they wish to settle in.

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Perpetual contracts are agreements between buyers and sellers without a specific expiration date, unlike other similar types of contracts such as options or futures. It is up to the buyer and the seller to decide when they want to perform the contract. They can hold the position for as long as they want (perpetually) and execute the contract trade at any time. This is a contract settled in cash; there is no actual delivery of the underlying cryptocurrency. In other words, traders can speculate on the price movements of an asset without needing to own the asset itself.

Perpetual contracts derive their value from the underlying cryptocurrency of the contract.

The contract price is a direct consequence of the fluctuation in the price of the underlying asset. Buyers can choose to buy the underlying cryptocurrency if they expect prices to rise in the future while sellers can initiate the contract if they think prices will fall in the future. to come up.

Traders can use leverage to increase their buying / selling power for perpetual contract trading. The leverage effect for perpetual contracts is set by the exchange operator based on their risk tolerance. The higher the leverage used by a trader, the easier it is to liquidate the position, as the margin ratio can quickly fall below the holding margin in volatile market conditions.

In order for perpetual contracts to converge on the price of the underlying assets, they rely on a scheduled payment between buyers and sellers known as the “finance rate mechanism”. You can think of it as a commission or a discount for traders to hold positions. This mechanism balances the demand of the buyer and the seller for the perpetual swap so that its price aligns with the underlying asset (index price). This reflects both the leverage used by each side as well as the delta between the index price and the perpetual contract price. Traders should be careful with funding periods as they may pay or receive funding fees to hold a position.

When there is positive funding interest, buyers “buy long” pay sellers “buy short”. Conversely, when the finance rate is a negative rate, sellers pay buyers. Likewise, when perpetual contracts are traded at a premium rate, the funding rate is positive. In this case, the buyers pay the sellers to make room for new short positions.

By introducing the finance payment, derivatives exchanges can encourage arbitrageurs to come and correct the contract price by taking the less popular side, which creates a better trading environment for all participants.

As mentioned earlier, the main reason why perpetuals have become so dominant is that they offer a lot more leverage compared to spot and because they can be marginalized in cryptocurrencies, eliminating the need for deal with the traditional fiduciary system.

In this context, Phemex is one of the most popular exchanges in the industry which offers perpetual contracts as a trading instrument. Considering the great popularity and demand for these trading instruments in the crypto trading ecosystem, Phemex is proud to have recently launched its ETH reverse contract. For clarity, it is important to distinguish between inverse and linear contracts as two separate tools for profiting from fluctuating prices.

When they first appeared, perpetual contracts were settled in crypto instead of USD. This was fundamental as derivatives exchanges have struggled to establish traditional banking partnerships given the perceived risk. In a reverse contract, traders deposit a specific cryptocurrency to begin with and these contracts settle in the underlying cryptocurrency as opposed to the quoted currency (traders should hold a more volatile asset as a margin). For example, if you were to trade ETH / USD, you would actually receive your payment in ETH itself. As you profit from a long position in ETH, you will receive an ETH payout, but for a lower amount because ETH itself is more expensive compared to USD. On the other hand, if the value of ETH / USD goes down, you will lose ETH at a higher rate because ETH itself is cheaper than USD. An easier way to understand this concept is to think about how the contract is used. Speculators and hedgers trading inverted perpetuals are trading contracts that are priced in dollars, but which guarantee their positions in crypto.

With the rise of stablecoins, crypto exchanges now offer straight-line settlement contracts that avoid touching fiat, but pay with more intuitive USD-style assets, such as USDT. The margin used for a linear contract is usually a stablecoin, so traders do not have to hedge their position to avoid the risk of holding the cryptocurrency. With linear perpetuals, speculators, hedgers and arbitrageurs who trade them are primarily concerned with their stable holdings because their contracts and PnL (Profit and Loss) are all measured in dollars.

While inverted perpetuals are the most popular type of contract, linear perpetuals have benefited from the recent increase in the number of stable coin users and market capitalization. Non-linear perpetuals have also benefited as they are extremely powerful hedging tools for long-term BTC holders who don’t want to sell their holdings in fiat.

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