What Are Perps in Crypto? Explaining Perpetual Swaps

Perpetual swaps, often called “perps” in the digital asset space, are derivative contracts popular in cryptocurrency markets. These instruments allow participants to engage with the price movements of various cryptocurrencies without directly owning the underlying assets. Their design blends features from traditional financial products, adapted for the 24/7 crypto environment.

Understanding Perpetual Swaps

Perpetual swaps are financial derivative contracts that enable traders to speculate on an asset’s future price, such as Bitcoin or Ethereum, without taking direct ownership of the asset itself. Unlike conventional futures contracts, perpetual swaps have no expiration date. This means positions can be held indefinitely, providing traders with flexibility that traditional futures do not offer.

These contracts are designed to closely mirror the spot price of the underlying asset, which is the current market price for immediate purchase or sale. Perpetual swaps typically allow for leverage, enabling traders to open positions larger than their initial capital.

Leverage refers to using borrowed funds to increase a trading position’s size. For example, with 10x leverage, a trader can control a position worth $10,000 with only $1,000 of their own capital. Trading perpetual swaps involves taking a “long” position, where a trader anticipates the asset’s price will increase, or a “short” position, where they expect the price to decrease.

Key Elements of Perpetual Swaps

Several specific components allow perpetual swaps to operate effectively in the crypto market. The “Index Price” serves as a real-time reference, representing the average price of the underlying asset across several major spot exchanges. This price provides a foundation for the contract’s valuation.

The “Mark Price” is a smoothed price derived from the index price and the contract’s trading price. This mark price is used to calculate a trader’s unrealized profits or losses and is also a determinant for liquidation. Exchanges typically use a smoothed mark price to prevent price manipulation and ensure fair calculations.

To initiate a leveraged position, traders must commit an “Initial Margin,” which is the minimum amount of capital required to open the trade. Once a position is open, a “Maintenance Margin” is the minimum amount of capital needed to keep that position active. If the capital in the trading account falls below this maintenance level, it can trigger a liquidation.

The “Funding Rate” is a periodic payment exchanged between long and short positions, typically occurring every eight hours. This mechanism aims to keep the perpetual swap’s price aligned with the underlying spot price. If the perpetual swap’s price is higher than the spot price, the funding rate is positive, meaning long position holders pay short position holders. Conversely, if the perpetual price is lower than the spot price, the funding rate is negative, and short position holders pay long position holders.

“Liquidation” is the automatic closing of a leveraged position by the exchange. This occurs when a trader’s margin balance drops below the maintenance margin requirement, typically due to adverse price movements against their position. This process prevents traders from incurring losses beyond their deposited margin and protects the exchange from absorbing those losses.

How Perpetual Swaps Function

Trading perpetual swaps begins with a trader selecting a cryptocurrency asset and deciding on the desired leverage. They then choose to open a long position, anticipating a price rise, or a short position, expecting a price decline, committing their initial margin to secure the trade. This initial capital acts as collateral for the leveraged position.

After opening a position, traders continuously monitor their unrealized profit or loss, which is calculated based on the mark price of the contract. The funding rate is automatically applied to open positions at predetermined intervals, typically every eight hours. This adjustment directly impacts the account balance, reflecting whether the trader pays or receives funds based on the prevailing funding rate.

Managing leverage and margin levels is ongoing throughout the life of a perpetual swap position. As the market price moves, the value of the position and thus the margin balance fluctuates. If the market moves unfavorably, causing the margin to fall toward the maintenance level, traders may need to deposit additional funds to avoid liquidation.

The liquidation process is an automatic safety mechanism. If the mark price moves significantly against a position, and the margin falls below the maintenance margin, the exchange will automatically close the position. This prevents further losses for the trader and protects the exchange from absorbing those losses. Any remaining funds after the liquidation fee are typically returned to the trader.

Traders can also manually close their positions at any time to realize profits or losses. This allows for flexibility in managing exposure to market movements. Closing a position effectively settles the trade based on the current market price.

Purpose of Perpetual Swaps in Crypto Markets

Perpetual swaps serve several functions within the cryptocurrency market, contributing to its unique structure and trading dynamics. Their lack of an expiration date allows for continuous trading, removing the need for traders to frequently roll over contracts. This is particularly appealing in the 24/7 nature of crypto markets and enhances trading flexibility.

These instruments provide leveraged exposure to crypto assets, enabling traders to amplify potential returns or losses with a smaller initial capital outlay. Participants can gain exposure to price movements without needing to hold the physical asset or commit large sums upfront.

Continuous trading and high liquidity often associated with perpetual swaps contribute to price discovery for various digital assets. The constant buying and selling activity helps establish a more accurate and real-time market price for cryptocurrencies.

Perpetual swaps can also be utilized by existing holders of physical cryptocurrency to hedge against potential price declines. By taking a short position in a perpetual swap, an asset holder can mitigate the risk of losses on their underlying holdings without selling them. This offers a method for managing portfolio risk in volatile markets.

Perpetual swaps enhance market efficiency by facilitating more dynamic trading and creating opportunities for arbitrage. They allow for rapid responses to market changes and help to balance supply and demand across different trading venues.