What are futures contracts?

A futures contract is an agreement to buy or sell a commodity, currency, or other financial asset at a predetermined price at a specific time in the future.

Unlike the traditional spot market, transactions in the contract market are not settled immediately. Buyers and sellers trade contracts that provide for settlement at a certain time in the future. In addition, users cannot directly buy or sell physical commodities or digital assets in the contract market. Instead, they trade contracts representing those assets, and the actual transaction of the assets (or cash) will occur in the future, when the contracts are executed.

Let’s take futures contracts of physical commodities such as wheat and gold as an example. In some traditional contract markets, delivering these contracts means delivering the physical commodity. Therefore, the gold or wheat must be properly stored and transported, which in turn incurs additional costs (called "storage costs"). However, many contract markets now support cash settlement, which means only settlement of equivalent cash value (no physical exchange).

In addition, the price of gold or wheat in the contract market may vary depending on the distance of the contract settlement date. The further the expiration date is, the higher the corresponding storage cost will be, the uncertainty of the price will also increase, and the greater the potential price difference between the futures market and the spot market.

Why trade futures contracts?

• Hedging and risk management: This is the main reason for the creation of futures contracts.

• Short-term exposure: Traders can bet on the performance of an asset even if they do not own it.

• Leverage: Traders can open positions that are larger than their account balance.

What Is it a perpetual futures contract?

Perpetual contract is a special futures contract. Unlike traditional contracts, perpetual contracts have no expiration date and users can choose to hold positions forever. In addition, perpetual contract trading is based on the underlying index price. It consists of the average price of an asset, influenced by major spot markets and relative trading volumes.

Unlike traditional contracts, the trading price of perpetual contracts is usually the same as or very close to the spot market. However, the biggest difference between traditional contracts and perpetual contracts is that the former stipulates a "settlement date".

What is the initial margin?

Initial margin is the minimum margin required when opening a leveraged position. For example, if the initial margin is 100 BNB, the user can buy 1,000 BNB with 10x leverage. Therefore, the initial deposit is 10% of the total order amount. Initial margin is a strong support for leveraged positions and plays the role of collateral.

What is maintenance margin?

Maintenance margin is the minimum collateral required to maintain the corresponding trading position. If the margin balance is lower than the maintenance margin, the user will receive a margin call notice (requiring them to fund their account) or be directly forced to liquidate. Most digital currency trading platforms choose the latter approach.

In other words, the initial margin is the amount committed when opening a position, while the maintenance margin refers to the minimum balance required to maintain the position. Maintenance margin changes dynamically, depending on market prices and account balance (collateral).

What is forced liquidation?

If the deposit is lower than the maintenance margin, your contract account will be forced to liquidate. Binance forces liquidation in different ways based on each user’s risk and leverage (collateral and net exposure). The larger the total position, the higher the proportion of margin required.

This mechanism varies by market and trading platform, but Binance has forced liquidation of Tier 1 positions (low net risk exposure (500,000 USDT) charges a nominal fee of 0.5%. After forced liquidation and payment of nominal fees, the remaining funds in the account will be returned to the user. If the balance is less than 0.5%, the account will be reset to zero.

Please note that after forced liquidation, users will need to pay additional fees. To avoid this, you can close the position yourself before the liquidation price is reached, or fund your margin balance to increase the gap between the liquidation price and the current market price.

What is the funding rate?

Funding consists of periodic payments between buyers and sellers, depending on the current funding rate. If the funding rate is greater than zero (positive value), longs (contract buyers) pay shorts (contract sellers) a funding rate. In turn, shorts pay a funding rate to longs.

The funding rate consists of two parts: interest rate and premium. The interest rate in the Binance futures market is fixed at 0.03%, while the premium index changes based on the price difference between the contract market and the spot market. Funding Rate Transfers are completed directly between users, and Binance does not charge any fees.

When the perpetual futures contract trades at a premium (price is higher than the spot market), the funding rate is positive and longs need to move to shorts Pay the funding rate. This is expected to drive prices lower as long positions are liquidated and new short positions are opened.

What is a markup price?

The mark price is an estimate of a contract's true value (fair price) compared to the actual transaction price (last price). Calculating the mark price can effectively avoid unfair liquidation during severe market fluctuations.

Thus, while the index price is related to the spot market price, the mark price represents the fair value of the perpetual futures contract. For Binance, the mark price is based on the index price and funding rate and is an important factor in calculating "unrealized profit and loss."

How to calculate profit and loss (PnL)?

PnL represents profit and loss, which can be divided into realized profit and loss and unrealized profit and loss. If you hold an open position in the perpetual contract market, profits and losses have not yet been realized and will change with market developments. After closing the position, unrealized profits and losses will be converted into realized profits and losses.

Realized profit or loss is the profit or loss from the closed position. It is not directly related to the mark price, only to the order related to the execution price. Unrealized P&L, on the other hand, is constantly changing and is the main driver of liquidation. Mark prices are therefore used to ensure that calculated unrealized profits and losses are accurate, credible and fair.

What is the protection fund?

In short, the protection fund can effectively prevent the balance of losing traders from falling into negative values, while ensuring that profitable traders receive income.

For example, suppose Alice has $2,000 in her Binance Futures account. With this funding, she established a 10x long position in BNB at a unit price of $20. Please note that the contract Alice purchased did not originate from Binance, but was provided by another trader. As the counterparty, Bob also has a short position of the same size.

Driven by 10 times leverage, Alice’s current position size is 100 BNB (worth US$20,000), with a mortgage of $2,000. However, if the price of BNB drops from $20 to $18, Alice may face automatic liquidation. This means that her assets will be forced to liquidate, and her $2,000 deposit will be lost.

If the system cannot close the position in time for some reason and the market price drops further, the protection fund will be activated at this time so that Make up relevant losses until the position is closed. Alice won't see much change here, because her balance will return to zero after the forced liquidation, but this will ensure that Bob gets corresponding benefits. Without a protection fund, Alice's $2,000 would not only be lost, but her account balance would even become negative.

However, in actual trading, her maintenance margin will be lower than the minimum requirement, and her long position may have been closed before then. The forced liquidation fee is paid directly by the protection fund, and the remaining funds are returned to the user.

Therefore, the protection fund mechanism aims to effectively use the deposits paid by traders who were forced to liquidate their positions to make up for the zero account Loss. Under normal market conditions, the protection fund is expected to continue to grow as users are forced to liquidate their positions.

To sum up, when the user is forced to liquidate the position before reaching breakeven or negative value, the protection fund will increase. In more extreme cases, the system may not be able to close all positions, in which case the protection fund will be used to cover potential losses. This situation is uncommon, but it can happen during times of severe market volatility or extreme lack of liquidity.

What is automatic deleveraging?

Automatic position reduction is a method of forced liquidation of positions by the counterparty. Automatic position reduction will only occur if the protection fund fails (certain circumstances arise). Although the probability of occurrence is extremely low, such events require profitable traders to use part of their profits to cover the losses of losing traders. Unfortunately, the digital currency market is highly volatile and the leverage provided by perpetual contracts is relatively high. Automatic position reduction cannot be completely avoided, but we will make every effort to reduce this probability.

In other words, counterparty forced liquidation is the final solution when the protection fund cannot fill all zeroed positions. Generally speaking, the positions with the highest profits (and leverage) also contribute the largest proportion to the auto-deleverage. Binance uses an indicator to inform users of their position in the auto-deleveraging queue.

Binance’s futures market system takes all necessary measures to avoid automatic deleveraging and minimizes its impact through multiple features. If automatic deleveraging does occur, counterparty liquidation will be performed at zero market fees. Affected users will be notified immediately and can re-enter the market at any time.