What is the trading mechanism of perpetual contract?

What is the Trading Mechanism of Perpetual Contract?

A perpetual contract, also known as a perpetual swap, is a type of financial derivative that mimics the price of an underlying asset, such as a stock or commodity. Unlike traditional futures contracts, perpetual contracts do not have an expiration date and can be held indefinitely.

Trading Mechanism

The trading mechanism of a perpetual contract involves the following steps:

1. Funding Rate Calculation

Every 8 hours, the funding rate is calculated by comparing the price of the perpetual contract to the spot price of the underlying asset. If the perpetual contract price is higher than the spot price, the buyers of the contract will pay a "funding fee" to the sellers. Conversely, if the perpetual contract price is lower than the spot price, the sellers will pay a "funding fee" to the buyers.

2. Mark Price Calculation

The Mark Price is a weighted average of the spot price and the perpetual contract price, and is used to determine the profit and loss (P/L) of the contract. The P/L is realized when the contract is closed or when the funding rate is paid/received.

3. Liquidation

If the P/L of a contract falls below a certain threshold, it will be liquidated. Liquidation is a forced closure of the contract, which results in the trader losing their entire investment.

4. Leverage

Perpetual contracts typically offer high leverage, which can amplify both profits and losses. However, using excessive leverage can result in significant risks.

Advantages of Perpetual Contracts

• Perpetual contracts can be held indefinitely, giving traders flexibility in their trading strategies.
• The funding rate mechanism ensures that the price of the perpetual contract remains closely aligned with the underlying asset.
• Perpetual contracts offer high leverage, providing potential for greater profits.

Disadvantages of Perpetual Contracts

• Perpetual contracts are subject to liquidation if the P/L falls below a certain threshold.
• Using excessive leverage can result in significant losses.
• The funding rate mechanism can add additional costs to traders, depending on market conditions.