Nowadays more and more people started trading Ethereum, this gave the rise to many new ways to capitalize on this promising new market and one of the most attractive and popular product nowadays is a derivative called an ‘Ethereum Perpetual Contact’. You may have heard a little about how it works and got interested in it. This article will explain what this is, some of its features and how it can be used to make money.
What is an Ethereum Perpetual Contract?
Briefly described, it is an agreement between a buyer and a seller on the future value of a certain amount of Ethereum. It is similar to a futures contract in that both sides agree to buy or sell Ethereum at a pre-determined price. But there is a major difference between these two types of contracts. Perpetual contracts don’t have an expiry date, which means you can sell or buy the positions and hold them for as long as you want. More importantly, it allows traders to profit from both bullish and bearish markets as you can choose the position to enter.
The word ‘contract’ means you don’t just hold your ETH and hope for the price to rise. Based on the current market trend, some analysis and your own judgment you can try to predict its future price and decide whether you want to go long or short. Going long means you buy in some Ethereum as you believe the price will go up, on the contrary, going short means you sell out some Ethereum as you expect the price to go down.
Above is the basic concept of an Ethereum perpetual contract, now we will talk about its mechanism and features to help you further understand its value.
How perpetual contract works
As previously mentioned perpetual contracts are an agreement between two buyers with one person selling (shorting) and one person buying (going long). This means that for every person going long there must be someone willing to go short. This needs to happen every time when opening a position, closing a position, or getting liquidated.
For example, you want to go long and you have 10 ETH, the price is now at $100 per ETH for a grand total of $1,000. You go long and buy $1000 contract’s worth of ETH. The price goes up to $120 per ETH and you sell back your $1,000 contract’s worth of ETH but this now only amounts to 8.34 ETH. Congratulations, you just made 10-8.34=1.66 ETH!
Initial and Maintenance Margin
An Ethereum perpetual contract is a margin trading product and can be traded with leverage, meaning that if you use a 100x leverage, the $1 worth of ETH that you put in will worth of $100 worth of ETH. this $1 is your initial margin. The higher the used leverage, the lower the initial margin. So far, exchanges offer maximum leverage of 100x leverage. And some exchanges even feature an adjustable leverage that allows you to change your leverage AFTER you opened your position, something that can come very handy when your initial margin is running out.
Obviously, platforms don’t want to lose out money from your risky trades and they only lend you this amount as your initial margin is used prioritarily when encountering a loss. Meaning that when your initial margin amount runs out you will get liquidated and your position automatically closed down.
In other words, when a trader suffers a loss and the initial margin reaches the maintenance margin, your positions will be forcefully liquidated. The maintenance margin is the minimum amount you have to hold to keep a position open and it differs in various exchanges and also depends on the number of your positions.
Insurance Fund, ADL, or Social Loss Mechanism
An insurance fund is an account that is used to cover the loss of liquidated traders to ensure that their contract loss is always covered. The Insurance Fund is platform-wide and is either replenished by the initial margin left when the liquidation happens over the Bankruptcy price. And it is used when it happens under said Bankruptcy price.
When the Insurance Fund is empty platforms use either a social loss system or an ADL system to cover the loss. A social loss system will have all profiting traders across the platform pay to cover the loss proportionally regardless of the leverage used.
On the contrary, an ADL system will systematically rank all traders by their profit percentage and leverage, select the highest leveraged and profited traders to be de-leveraged first, which allows lower risk takers to have a lower chance to be selected to cover the contract loss.
In perpetual contracts, investors do not have to worry about settlement fees and roll over costs, but should pay close attention to the funding periods as they may pay or receive a funding fee for holding a position.
The funding rate is based upon the spot price. If the perpetual contract worth more than the spot price, long positions will pay short positions at a rate, depending on the difference between their prices. It also works in the opposite situation when spot price worth more. The funding rate will continuously change so you won’t know in advance how much your funding costs will be.
To summarize, an Ethereum perpetual contract resembles a futures contract because it offers high leverage. On the other hand, the contract closely tracks the spot price and never expires. Users can hold a position until they decide to close it.
This concludes today’s article on what is a perpetual contract, as well as what kind of mechanism and features it has. As we’ve seen Ethereum contracts offer traders the possibility of earning from both bullish and bearish markets, use high leverage to multiply their profits, and hold positions for as long as they want. We hope you learned a lot, enjoyed the read, and stay tuned for more great content.