Perpetuals and Leverage

Learn how one of the riskiest forms of crypto trading works

TLDR:

• Traditional futures contracts allow market participants to hedge and speculate on price. Large markets have grown out of the financialisation of these contracts.

• Perpetuals futures contracts are an evolution of traditional futures contracts that have no expiry date, they are ideal for price speculation on digital crypto assets.

• Leveraging your margin (ie. collateral) with perpetuals can allow you to take on much riskier plays with a much higher potential outcome in both directions.

• Exchanges offering perpetuals are very common in crypto, below you can see an example of how to use the GMX exchange to trade perpetuals with leverage.

• Warning, trading perpetuals with leverage is one of the easiest ways to lose all your money fast, don’t risk more than you can afford to lose.

Crypto markets are fast evolving and have all sorts of ways to trade them.

This week I wanted to dive into one of the more risky and less understood forms of trading, namely leverage trading with perpetual futures contracts.

Trading with leverage is one of the easiest ways to lose money if you’re not careful, but also one of the best ways to see noticeable results if you don’t have much money and want to move fast. So let’s dive in and take a look!

What are Futures Contracts?

First we need to start by understanding a bit about the history of traditional futures contracts. Futures originally began as a way for participants in certain industries to hedge against price volatility.

In an agricultural context, Alice may promise to buy Bob’s wheat at $1k per bushel 6 months from now regardless of the market price then. Locking in price allows both consumers like Alice and producers like Bob to plan appropriately for the future.

However, as a second order effect, futures contracts create a financial element as arbitrageurs and speculators can buy and sell them to speculate on price differences against the spot market (ie. the actual current market price).

As an example a wheat shortage may raise the price to $2k per wheat bushel, so an arbitrageur called Charlie could spot the opportunity and buy the contract off Alice for $1.5k, then use it to buy Bob’s wheat for $1k and sell it to the market at $2k, making himself a $500 profit per bushel!

This financialisation of futures contracts has grown into a massive “futures market”, and today while physically-settled futures contracts still exist, where the underlying good is delivered to the buyer, many futures contracts are cash-settled and don’t even handle the underlying asset. And cash-settled contracts essentially just create a marketplace for people to speculate on whether an asset’s price will go up or down.

What are Perpetual Futures Contracts?

Perpetual futures contracts, or simply perpetuals or just perps, are an evolution of the traditional futures concept. They do away entirely with the expiry date of contracts, making all contracts run forever (ie. be “perpetual”) and essentially create marketplace for price speculation and hedging on the direction of an asset’s price.

If Alice is now trading perpetuals on the price of Bitcoin, then when Alice buys a $60k BTC perp with the expectation of it going up and she closes it when the spot price reaches $80k, then she makes that $20k profit from Bob who was betting against BTC on the other side of the market.

Since there are no arbitrageurs here, perpetuals introduce an innovative mechanism known as a “funding rate” where those betting on the perp’s price deviating further from spot price, are made to pay a fee to those betting that it’ll move back towards spot. This financial incentive acts a bit like a magnet attracting the perp’s price back to spot price over the long-term.

Perpetuals are neither better nor worse than traditional futures contracts, they are just different and cater very specifically to those speculating on price, since they are almost always cash-settled. They allow people to speculate on the direction of price without needing to buy the underlying asset and have grown a lot in the crypto world.

Importantly, just like traditional futures, perpetuals can allow for leverage, and this is where they become a very interesting alternative to buying the spot asset.

What is Leverage trading?

Perpetuals, like traditional futures contracts, can be traded with leverage. Leverage allows you to trade with more money than you actually have increasing your risk exposure, meaning you can both make more money or lose more money more quickly.

Leverage is traded at multiples of the margin (ie. the collateral that you put up) and can be anything from 1x to 100x of your collateral or more, it all depends on what the exchange allows for and what risk you’re willing to take.

The higher the leverage the more risk you take, meaning the easier it is for you to be either margin called (ie. have your collateral taken away from you unless you post more collateral) or to make higher multiples when the price goes in your direction.

So if Alice is once again trading perps with Bitcoin at $60k and puts down a $6k bet will go up at 10x leverage, then when Bitcoin hits $80k and she closes the contract she’ll have made $20k even though she only started with $6k. Whereas, if she’d bought 0.1 spot Bitcoin at $60k and sold it at $80k she would have only made $2k!

However, if Bitcoin trades down to $54k Alice’s long bet could be liquidated for her entire $6k unless she adds more collateral, because the $6k drop from $60k to $54k would eat up all her margin.

As you can see the bigger the leverage the bigger the amplification in either direction, small shifts in price can lead to either big gains or big losses.

Example of leverage trading on GMX

There are plenty of great perpetuals trading exchanges in crypto, both for CEXs and DEXs. For CEXs, Binance, BitMEX and OKX are the top options. Meanwhile for DEXs if you’re in the Ethereum ecosystem try out dYdX, on chains like Arbitrum and Avalanche GMX is the main player, and for Solana it’s Mango Markets.

For this post I’ve chosen to use GMX simply because the fees are low on Arbitrum and it’s pretty simple to use. I don’t think it’s necessarily better than the others nor have any personal preference here.

To start, launch the GMX app, connect your wallet and select the ETH/USD pair. On the right side you’re given the option to go “long” or “short” on the price of ETH, this essentially means bet on the price going up or down respectively.

If I go long with 0.001 ETH then I can push the leverage slider up to a maximum of 50x which is essentially 0.05 ETH - although some fees that reduce to 0.048 as above.

This means that I’m putting a collateral of around $3 but getting $160 worth of exposure at current ETH prices. If ETH goes up slightly I can make easily much more than $3 in minutes. However, if it drops below the liquidation price of $3274.27, which is only a small change in price, then it will swallow up my $3 ETH collateral.

Meanwhile if I decide to short ETH then the logic is the same just reversed, and now I’m using my $160 worth of exposure and hoping that the price of ETH will drop. In the example shown below I will get liquidated if ETH goes up past a price of $3,335.81.

On commiting to a long at 50x leverage with $3 worth of ETH GMX gives the following confirmation box before you go through with it.

On confirmation GMX will now show you the position you opened at the bottom, and the price at which it was opened along with the liquidation price on the price graph:

Once you’re done you can close the position and it will show the history of your transactions. Admittedly this isn’t very easy to interpret on GMX but essentially it shows the price you entered and exited at, and their corresponding transactions.

In this example I made a miniscule gain by exiting slightly above my entry price, but if ETH’s price had shot up I could have made a lot more. So you see even with a small amount of money I can have a large gain on my margin by trading with leverage!

Warning!

While perpetuals and leverage trading is pretty fascinating it’s also one of the easiest ways to lose all your money.

Yes, it has huge potential upside, as it can take you from $1,00 to $10,000 in minutes, but it can also do the same in the opposite direction.

Due to this, leverage should really be used with only a small % of your total capital. It could make sense for example to use 5-10% of your overall capital to take riskier bets, which may include trading perps.

Most importantly I’d highly recommend to never put in more than you can afford to lose. If losing the money you’re trading means you’re not going to be able to feed yourself or keep a roof over your head, then is it really worth the risk?

Either way, have fun trading, stay safe, and don’t say I didn’t warn ya!