A futures contract is an agreement to buy or sell a product, currency, or another instrument at a specified price at a specified time in the future.
Unlike typical market transactions, future contract are not transactions that settle immediately. In this case, a transaction contract sets conditions for a specific date. Future contracts also do not allow users to buy or sell digital currency or products directly. Instead, they enter into a contract that will enable them to conduct future trading operations.
You can also read: What Is a Blockchain Consensus Algorithm?
For example, suppose you set up a futures contract for a physical product such as a silver futures contract. In traditional futures markets, these contracts are for the transportation and delivery of physical goods, and anything specified in the futures contract includes shipping costs or even additional costs. However, new futures markets have a cash settlement system and work in a new way.
For example, the price of silver may change on the date of the futures contract. The longer the final date of the agreement, the higher the costs incurred and the more likely it is that the original price will change in the future.
Why use future contract?
- One of the most important reasons for creating future contract is risk and capital management.
- In this way, traders can also set a futures contract on a product if they do not have one, provided they can create trading conditions on a specific date.
- There is leverage in this type of contract. The trader can set up future contract that hold more assets than the current account balance.
Perpetual futures contract
Perpetual contracts are also a type of futures contract, but they do not have any expiration date, unlike traditional methods. Therefore, each party to the transaction can keep the contract as long as it wants. In addition, Perpetual contracts are based on a type of price index. The price index includes the average price of a product or currency based on the market and its trading volume.
For this reason, unlike other future contract, these types of contracts are usually set at an average price that is considered the reasonable price of the goods. However, if the market changes, the price of goods will change drastically from the average price. The most significant difference between traditional futures and Perpetual contracts is their expiration date.
The initial margin is the minimum amount you have to pay to activate a leveraged position. As an article, if you buy 1000 BNB with an initial margin of 100 BNB, you have specified 10% of the initial margin. This amount of margin helps you maintain your leverage position as a guarantee.
What is the maintenance margin?
The maintenance margin is also the minimum amount of collateral you must determine to keep the transaction open. If your margin balance drops below this level, you will face a margin call or be dissolved. Most transactions in cryptocurrencies involve the dissolution method.
In general, the initial margin is the amount you pay to open a position, and the maintenance margin is the minimum amount you have to maintain the position. The maintenance margin is quite dynamic and varies based on the market price or the amount of your capital.
What is liquidation?
If your collateral is less than the maintenance margin, the market will liquidate your account. Dissolving the account also varies depending on the transaction you make. Liquidation price is determined based on the risk and leverage of each user. The larger the position, the more margin is needed.
To prevent liquidation, you must either close your position before reaching the liquidation price or increase your inventory. In this case, the distance between the amount of liquidation and the market price is different.
What is the funding rate?
Funding based on regular payments between the buyer and the seller is established based on the funding rate. The opposite also happens with negative funding rates.
The funding rate is based on two components—first, the demand rate and then the premium. Rate demand changes from one transaction to another and the premium will vary based on changes in futures and spot prices.
When Perpetual contracts trade on premium, long positives have to pay for shorts because a positive funding rate occurs. In such a situation, the price decreases, the longs close their position, and the shorts open a new position.
What is the mark price?
Mark Price is the fair price of a contract compared to other recently registered agreements. Mark Price calculation calculates the occurrence of unfair liquidations. If the index price is related to the point-to-point cost of the market, Mark Price determines the fair price for a Perpetual futures contract. Price branding, however, is based on index price and funding rate and is a vital part of unrealized PnL calculations.
What is PnL?
PnL also refers to profit and high and is divided into realized and unrealized parts. When you open a position in a market with a perpetual contract, PnL is in unrealized mode and changes its price in response to market movements. PnL also becomes Realized when you close your position.
Realized PnL is derived from profits and many closed positions but has no direct connection with Mark Price. This entity is used for price processing. Unrealized PnL is also constantly changing prices and is one of the main levers of liquidation.
The Insurance Fund is precisely the fund that does not allow traders’ accounts to fall below zero while ensuring that winning traders profit.
Let us illustrate with an example. Suppose Sarah invests $ 2,000 in a futures contract. The deal is closed with 10 BNBs priced at $ 20. Sarah got the sale from another deal called Jack. Sarah has a long position, and Jack has a short position.
Sarah currently has a $ 1,000 BNB with a $ 20,000 guarantee and a $ 2,000 guarantee with ten times the leverage. If the price of BNB drops from $ 20 to $ 18, Sarah’s position will be closed automatically; it means that Sarah’s property dissolves, and her $ 2,000 guarantee is lost.
Suppose, for any reason, the system does not automatically close its position, and the price drops further. In that case, the Insurance Fund activates to compensate for the loss for the closed position. Of course, this may not work out well because of Sarah’s loss of capital, but on the other hand, Jack can make a profit. Without the Insurance Fund, Sarah’s financial account would not only have been reduced from $ 2,000 to zero but could even have been negative.
Because Sarah’s maintenance margin was less than specified, it was possible to close her long position earlier. Liquidation costs go directly to the Insurance Fund, and any remaining capital is returned to the user. Therefore, the Insurance Fund can be a means to prevent users from going bankrupt in future contract. In a traditional market, the Insurance Fund increases as the user status are dissolved.
When the user is liquidated before facing a negative account, the Insurance Fund gets even higher amounts. In a critical situation, the system can not close all conditions automatically, and the entire insurance fund will be used to compensate for losses.
What is Auto-deleveraging?
If the Insurance Fund does not operate at a particular time, Auto-deleveraging is enabled. This situation will cause the traders who have benefited from the contract to compensate the losses of the losing traders. Due to severe market fluctuations, all losses will never be reimbursed.
Dissolution of the other party is the last step when the insurance fund can not compensate for the bankruptcy. In this case, traders who have more participation are considered as more profitable positions. The system generally prevents auto deleveraging, but due to high fluctuations, anything is likely to happen.
A futures contract is one of the best options for currency or product transactions, according to which you can set a specific date and complete the process when a specific date based on the transaction arrives. In this case, the risk of transactions is greatly reduced, and in general, you can sign a futures contract without sufficient capital. There are many things to consider when it comes to futures contracts. If you have any questions about the entities, you can send them to us in the comments section.