Futures and perpetuals: basis, funding and leverage
Futures are among the most traded contracts in the world, used for everything from oil and wheat to stock indices and interest rates. Perpetual futures, born in crypto, are now the most traded crypto product of all.
How futures are priced
A future's fair price is spot plus the cost of carry: the financing cost of holding the asset until expiry, plus storage, minus any income (dividends, for an index). The gap between future and spot is the basis. As expiry approaches, the basis shrinks to zero and the future converges with spot.
Contango and backwardation
- Contango: later futures trade above nearer ones. Normal when storage and financing costs are high.
- Backwardation: later futures trade below nearer ones. Usually a sign of tight supply now.
The shape matters for anyone rolling positions. Investors in commodity funds that roll futures in steep contango can lose money even if spot prices rise. In April 2020, with storage full, the expiring WTI oil future settled at around minus $37 a barrel: holders had to pay to get rid of it.
Daily settlement
Futures are marked to market every day. Gains are credited and losses debited to your margin account. If your balance falls below the maintenance margin, you get a margin call: post more or be closed out.
Perpetual futures
A perpetual (perp) is a future with no expiry. Without expiry there's nothing forcing it to converge with spot, so perps use a funding rate instead, typically exchanged every eight hours:
- If the perp trades above spot, funding is positive: longs pay shorts. That makes holding longs expensive and pulls the price back down.
- If it trades below spot, funding is negative: shorts pay longs.
Funding is the credit or debit that appears in your account each period, depending on your side. Persistently high positive funding shows crowded, leveraged longs, a common precursor to sharp flushes.
Leverage and liquidation
Crypto exchanges offer very high leverage on perps. At 20x, a 5% move against you wipes out your margin and the exchange liquidates the position automatically. Liquidations create forced selling (or buying), which can trigger more liquidations: a cascade.
Basis trades
When futures trade rich to spot, traders can buy spot and short the future to lock in the basis. The same idea in Treasuries, done with heavy leverage by hedge funds, is large enough that regulators watch it as a systemic risk.
Key takeaway
Futures link today's price to tomorrow's through the cost of carry. Perps replace expiry with funding. Both are leveraged, and leverage decides who survives a sharp move.
Educational content only, not financial advice. Options involve significant risk and are not suitable for everyone.