What are Futures? - Perpetual Protocol 🥨

Derivative contracts come in all shapes and sizes. In this article, we’ll explain what futures contracts are, how they work and how they differ from perpetual futures.

The concept of futures can be traced back to the ancient world, recorded by the Hammurabi code thousands of years ago, stating that goods must be delivered on an agreed-upon price at a date in the future based on a written contract with witnesses present. Arising from the need to hedge against uncertainty, futures contracts provided insurance to farmers in case of a failed crop or poor weather conditions.

Fast forward to the turn of the 17th century, and the first modern futures exchange was the Dojima Rice Exchange in Osaka, Japan, which allowed speculators to trade rice futures contracts. Rice itself was a currency in those times, with samurais receiving their salary in this commodity.

Many of the rules and practices established by the Dojima Rice Exchange were inherited by modern financial markets and influenced modern exchanges, like the Chicago Mercantile Exchange (CME).

The CME itself offers futures contracts for cryptocurrencies, first for Bitcoin since late 2017 and then for Ethereum since early 2021. With a brief historical overview of futures contracts out of the way, let’s explain what purposes these derivatives serve.

Futures Explained

The purpose of a futures contract agreement is to allow trades to buy or sell a specific commodity, asset, or security at a set future date for a set price. For example, the CME’s futures contract for ETH with September expiry is denoted as ETHU2, for the October expiry it is ETHV2, for the November expiry it is ETHX2, and so on.

At the expiration of a futures contract, the buyer is obligated to buy and receive the underlying asset, while the seller is obligated to provide and deliver the underlying asset. Futures contracts are available for a wide variety of asset types, such as commodities, stock indices, currencies, and even cryptocurrencies.

Futures contracts can be physically settled or cash settled. Physically settled futures are usually used by companies so that they can lock in a price of a commodity they require as an input for production, while traders who want to speculate can use cash-settled futures. When these contracts are closed out, traders receive the difference between the original trade price and the closing trade price. To ensure fairness, trading venues that offer futures typically use a time-weighted average price to determine the price at expiration.

Here’s an example of how futures contracts are used. Suppose a rice farmer wants to lock in a certain price for their produce and protect themselves from potential fluctuations in the price. Assume that the current price of 200 hundredweights of rice is $17, and the farmer wants a price of at least $20 to make a profit from their harvest.

To protect against any unforeseen circumstances, such as a decline in prices, the farmer can sell some futures contracts priced at $20 with an expiry of six months. Even if the price declines to $15 after six months, the farmer can sell their harvest for $20 per 200 hundredweight, since the buyer of the futures contract is obligated to buy and take delivery of the rice.

While hedging benefits the farmer when the price remains constant or falls, there is a small loss incurred when the price rises above the set price in the futures contract.

Backwardation & Contango

Because there’s uncertainty regarding the spot price at expiration for different futures contracts (i.e., no one will know for sure what the spot price will be in six months time when a futures contract expires), futures can often trade at a persistent discount or premium, which is known as the basis. Usually quoted as an annualized percentage, the basis is present since there is a positive or negative time value associated with the uncertainty around the expiry price.

A futures curve shows the prices of various futures contracts over different expiration months at a certain point in time, and is also known as the term structure. The futures curve for ETH displayed below shows that the market anticipates a price of around $1570 by the end of September and the term structure is relatively flat into 2023, suggesting there are expectations of very low volatility in the upcoming months.

Source: laevitas

There are two important terms you should know that describe when futures are trading at a discount or at a premium to spot prices:

Backwardation: which refers to a situation in which the current price of the underlying asset (or spot price) is higher than the futures price, indicating that there’s an expectation that the spot price will fall in the future as the expiration date of the futures contract approaches. When there’s backwardation, trades can profit from selling short the asset at the current price and buying the futures at a lower price.
Contango: which refers to the opposing situation, where the spot price of the underlying asset is lower than prices trading in the futures market, indicating that there’s an expectation that the spot price will rise in the future as the expiration date of the futures contract approaches. When there’s contango, traders can profit from buying the asset at the current price and selling futures at a higher price.

Key Differences Between Futures and Perpetual Futures

Futures and perpetuals share some features, such as the ability to acquire leverage and utility in terms of both hedging or speculation. There are also similar market neutral trading strategies you can employ to earn a yield with both of these derivative products, e.g., the cash and carry approach to trading futures is very similar to basis trading strategies utilizing perpetuals.

But there are two fundamental differences between futures and perpetuals.

1. Expiration

The main difference between futures and perpetual futures is that the former expires at a certain date, while the latter have no expiration at all. That means when trading futures, you may need to roll over your contracts if you want to keep a position open.

The lifespan of a futures contract is generally one month or one quarter and prior to expiration, a trader will have to choose between closing the position, rolling over their position, or letting the contract expire.

Rolling over involves selling a futures contract that is approaching expiry, then entering the same position in a longer-dated future with an expiration date that’s further out. Liquidity may start to taper off as expiry approaches, so traders should rollover their contracts at least several days before expiration.

However, as implied by the name, perpetual futures positions remain open indefinitely until the trader decides to close it out or becomes liquidated. So when trading perpetuals, you do not have to worry about expiry dates or have to re-establish your long or short position.

2. Funding Rate

While futures contracts will tend to converge with the spot price of the underlying asset at expiry, there is no expiration for perpetuals, so there’s a need for a mechanism to keep the price of the perpetual contract in line with the price of the asset it’s tracking.

The mechanism used to achieve this is the funding rate (which is non-existent in futures), where payments are exchanged between traders on the long side and short side based on the difference between the perpetual price and the spot price. Because of the way the funding rate anchors a perpetual’s price to the price of the underlying asset, it’s much more similar to trading spot assets and there’s no forward risk.

Depending on which side of the market you’re on and the current funding rate, traders utilizing perpetuals will either receive funding payments or have to pay them according to the size of their position.

Learn more about funding payments here.

The funding payments may sometimes become an additional cost for traders, depending on which side of the market they’re on. However, you can also earn funding fees, which may complement your profits. For example, if a trader is long and the funding rate is negative, but the price goes up, their position will earn them money and they’ll also receive payments from traders who are short.

Summary

Futures and perpetuals are very similar products in that they both allow leveraged trading and are both derivative contracts tracking the price of an underlying asset. However, the difference between them is that perpetuals never expire and a funding rate is utilized to stay in line with the price of the underlying asset, making these trading instruments a lot simpler and much more similar to spot trading.