What are Perps and How to Use Them

Perpetual futures, commonly called "perps," are derivative contracts that allow traders to speculate on the price direction of assets with leverage, without an expiration date. These instruments have revolutionized digital asset trading by combining the benefits of futures contracts with the flexibility of spot trading.

Historical Evolution of Derivatives Trading

The concept of futures trading traces back to the mid-19th century Chicago grain markets, where farmers and merchants needed tools to hedge against price volatility. The Chicago Board of Trade (CBOT), established in 1848, formalized these contracts to standardize grain trading.

Traditional futures contracts required physical settlement or cash settlement at expiration, creating rollover complexity for traders wanting continuous exposure. This limitation persisted until 2016 when BitMEX introduced the first cryptocurrency perpetual futures contract, eliminating expiration dates through a funding rate mechanism.

BitMEX's innovation solved a fundamental problem: how to maintain price alignment with the underlying asset without contract expiration. Their solution used periodic funding payments between long and short positions, creating a self-correcting mechanism that keeps perpetual futures prices anchored to spot prices.

What are Perpetual Futures?

Perpetual futures are derivative contracts that track the price of an underlying asset but differ from traditional futures in several key ways. As one financial analyst notes, perpetual futures create a system where "winners get paid by losers every [settlement period]" through the funding mechanism, making them particularly attractive for traders seeking frequent settlement opportunities [Bits About Money].

No expiration date: Positions can be held indefinitely without rollover
Leverage capability: Trade with borrowed capital to amplify exposure, often up to 100x compared to traditional markets' 2-4x [Bits About Money]
Funding mechanism: Periodic payments maintain price convergence with spot markets
Cash settlement: No physical delivery required
Mark-to-market: Positions are revalued continuously based on current market prices
Massive market size: Perpetual futures volume is typically "6-8 times larger than spot" trading, demonstrating their popularity as capital-efficient trading instruments [Bits About Money]

The Funding Rate Mechanism

The funding rate is the cornerstone of perpetual futures, ensuring price convergence between the perpetual contract and the underlying spot asset. This mechanism operates through periodic payments between traders holding long and short positions.

How Funding Rates Work

Funding rates are calculated using a combination of the interest rate differential and a premium/discount component:

Funding Rate = Interest Rate + Premium/Discount

The interest rate component is typically fixed (often 0.01% per 8-hour period), while the premium/discount reflects the difference between the perpetual price and the underlying index price.

Funding Rate Calculation Example

If Bitcoin spot price is $40,000 and the perpetual trades at $40,200:

Premium = ($40,200 - $40,000) / $40,000 = 0.5%
If interest rate = 0.01%, total funding rate = 0.01% + 0.5% = 0.51%
Long positions pay 0.51% of their position size to short positions
This payment incentivizes arbitrageurs to short the perpetual and buy spot, bringing prices back into alignment

Funding Payment Schedule

Most platforms calculate funding every 8 hours at fixed times (typically 00:00, 08:00, and 16:00 UTC). The rate is determined by the time-weighted average premium during the preceding period, providing predictability for traders.

How Perpetual Futures Work

Long vs Short Positions

Long (Buy) Positions: Profit when the asset price increases. If you open a long Bitcoin position at $40,000 with 2x leverage using $1,000 margin, you control $2,000 worth of Bitcoin. If the price rises to $45,000, your profit is $500 (25% price increase × $2,000 position size = $500 profit on $1,000 margin = 50% return).

Short (Sell) Positions: Profit when the asset price decreases. Using the same example in reverse, if you short Bitcoin at $40,000 and it falls to $35,000, you profit $500 from the $5,000 decline on your $2,000 position.

Leverage and Margin Requirements

Leverage amplifies both potential profits and losses by allowing traders to control larger positions with less capital:

2x leverage: 50% initial margin requirement ($1,000 controls $2,000)
10x leverage: 10% initial margin requirement ($1,000 controls $10,000)
20x leverage: 5% initial margin requirement ($1,000 controls $20,000)
50x leverage: 2% initial margin requirement ($1,000 controls $50,000)

Higher leverage requires less capital to open positions but increases liquidation risk. Most platforms use a maintenance margin system where positions are liquidated if unrealized losses reduce the margin ratio below a minimum threshold.

Leverage Risks and Liquidation Mechanisms

Understanding Liquidation Risk

Liquidation occurs when a position's unrealized losses reduce the margin below the maintenance requirement. The liquidation price can be calculated as:

Long Liquidation Price = Entry Price × (1 - 1/Leverage + Fees)

Short Liquidation Price = Entry Price × (1 + 1/Leverage - Fees)

For example, a long position at $40,000 with 10x leverage would be liquidated around $36,400, representing just a 9% adverse price movement.

The March 2020 Liquidation Cascade

The March 12-13, 2020 market crash provides a stark example of how leverage amplifies systemic risk. As Bitcoin fell from $8,000 to below $4,000 in hours, cascading liquidations occurred:

Initial selloff: Traditional markets crashed due to COVID-19 concerns
Leveraged long liquidations: Highly leveraged Bitcoin longs were forced to sell
Price acceleration: Forced selling pushed prices lower, triggering more liquidations
System stress: Some exchanges experienced outages, preventing traders from managing risk
Deleveraging events: Major platforms like BitMEX experienced automatic deleveraging, closing profitable positions to cover losses

This event demonstrated how leverage can amplify market volatility and create systemic risks during extreme market conditions. Many traders lost entire accounts despite being "right" about Bitcoin's long-term direction. During such extreme events, exchanges rely on "insurance funds" to cover losses, but these can become insufficient during severe market stress, leading to Automatic Deleveraging (ADL) where profitable positions are retroactively reduced to cover system losses [Bits About Money].

Mitigating Liquidation Risk

Use stop-loss orders: Exit positions before reaching liquidation levels
Monitor margin ratios: Add margin when positions approach maintenance requirements
Avoid maximum leverage: Use conservative leverage ratios relative to expected volatility
Diversify timeframes: Don't concentrate all positions in similar market conditions

Trading Strategies and Applications

Hedging Strategies

Perpetual futures excel as hedging instruments for both institutional and retail participants:

Portfolio Hedging: If you hold $100,000 in spot cryptocurrencies and expect short-term downside, you can open short perpetual positions equivalent to your holdings. This creates a market-neutral position where gains from shorts offset spot losses.

Basis Trading: Exploit price differences between perpetual and spot markets. This strategy allows market makers to execute "delta-neutral" trades that profit from price convergence while remaining insensitive to directional price movements [Bits About Money]. When perpetual futures trade at a premium to spot (positive basis), traders can:

Buy the underlying spot asset
Sell an equivalent amount of perpetual futures
Collect funding payments while maintaining market-neutral exposure
Profit from basis convergence and funding income
Benefit from the economic incentives built into the perpetual futures mechanism that naturally drive price convergence

Cross-Exchange Arbitrage: Exploit price differences between exchanges by simultaneously buying on the cheaper exchange and selling on the more expensive one, capturing the spread while remaining market-neutral.

Directional Trading

For traders with market views, perpetual futures offer capital-efficient ways to express directional bets:

Leveraged longs: Amplify exposure to expected price increases
Short selling: Profit from expected price declines without borrowing spot assets
Swing trading: Capture multi-day price movements with leveraged positions

Position Sizing and Risk Management

The Kelly Criterion for Position Sizing

Optimal position sizing can be calculated using the Kelly Criterion:

Kelly % = (Win Rate × Average Win) - (Loss Rate × Average Loss) / Average Win

For example, if your strategy wins 60% of the time with average wins of 3% and average losses of 2%:

Kelly % = (0.60 × 3) - (0.40 × 2) / 3 = (1.8 - 0.8) / 3 = 33.3%

This suggests risking 33.3% of capital per trade, but many traders use 25-50% of the Kelly percentage to account for estimation errors and reduce volatility.

Risk Management Framework

1. Maximum Risk Per Trade: Never risk more than 1-3% of total capital on a single position. This ensures that a string of losses won't deplete your account.

2. Portfolio Heat: Limit total risk across all open positions. If you have 10 positions each risking 2%, your portfolio heat is 20% - meaning you could lose 20% of your capital if all trades hit their stop losses simultaneously.

3. Leverage Limitations: Use leverage conservatively relative to volatility:

High volatility assets (altcoins): Maximum 2-5x leverage
Medium volatility assets (ETH): Maximum 5-10x leverage
Lower volatility assets (BTC): Maximum 10-20x leverage

4. Stop Loss Placement: Set stop losses based on technical levels rather than arbitrary percentages. Common approaches include:

Below/above key support/resistance levels
Outside the daily average true range (ATR)
At levels that invalidate your trading thesis

5. Time-Based Exits: Close positions that don't move in your favor within expected timeframes, even if stop losses aren't hit. This prevents capital from being tied up in non-performing positions.

Advanced Risk Metrics

Value at Risk (VaR): Calculate the maximum expected loss over a specific timeframe at a given confidence level. For example, a daily 95% VaR of $1,000 means there's a 5% chance of losing more than $1,000 in a single day.

Maximum Drawdown: Track the largest peak-to-trough decline in your account. If your maximum drawdown exceeds 20-25%, reassess your risk management approach.

Sharpe Ratio: Measure risk-adjusted returns by dividing excess returns by return volatility. A Sharpe ratio above 1.0 is generally considered good for leveraged trading strategies.

Major Perpetual Futures Platforms

Decentralized Exchanges

Hyperliquid: Leading decentralized perpetual exchange featuring:

On-chain orderbook with sub-second execution
Up to 50x leverage across hundreds of markets
Competitive fee structure (0.02% maker, 0.05% taker)
Advanced order types and portfolio margin
No KYC requirements for basic trading

dYdX: Pioneer in decentralized perpetuals with:

Layer 2 scaling for reduced transaction costs
Professional trading interface
Governance token rewards for traders
Institutional-grade risk management

GMX: Unique liquidity model featuring:

Multi-asset liquidity pools (GLP)
Zero slippage trading up to position limits
Yield-bearing liquidity provision
Cross-chain availability (Ethereum, Arbitrum, Avalanche)

Centralized Exchanges

Binance Futures: Largest perpetual futures platform by volume:

Deep liquidity across all major and minor cryptocurrencies
Up to 125x leverage on Bitcoin
Advanced charting and API access
Cross and isolated margin modes

ByBit: Popular among retail traders:

User-friendly interface
Comprehensive mobile trading app
Regular trading competitions and bonuses
Multi-language support

Conclusion

Perpetual futures represent a significant evolution in derivatives trading, offering unprecedented flexibility for both hedging and speculation. They operate as what economists call a "closed system" where trading gains are directly offset by trading losses, creating efficient price discovery through economic incentives [Bits About Money]. However, their power comes with substantial risks that require careful management.

Success in perpetual futures trading depends on understanding the underlying mechanisms, implementing robust risk management practices, and maintaining discipline in position sizing. The March 2020 crash serves as a permanent reminder that leverage amplifies both profits and losses, and that market conditions can change rapidly. Understanding that exchanges can forcibly close overleveraged positions through liquidations, and that insurance funds may prove insufficient during extreme stress, helps traders appreciate the systemic risks inherent in leveraged trading.

Whether using perpetual futures for hedging existing portfolios or expressing directional views, traders must respect the instruments' power and maintain appropriate risk controls. The combination of historical knowledge, mechanical understanding, and disciplined risk management provides the foundation for successful perpetual futures trading. As the market continues to mature, perpetual futures will likely remain a cornerstone of crypto trading infrastructure, providing sophisticated participants with arbitrage opportunities while serving as capital-efficient tools for risk management and speculation.