Perpetual futures are widely used instruments because they allow us to benefit from the revaluation of assets with even more profit than if we simply bought the asset.
However, we have to know how to manage their risk so that trading futures does not turn into a tragedy.
Today we are going to see how to mitigate the risk of being liquidated in Perpetual Protocol.
How it works
Perpetual Protocol is a platform for trading perpetual cryptocurrency futures on DeFi.
It works in a similar way to lending protocols, in the sense that you have to deposit assets as collateral in order to trade.
However, there is an important difference. Perpetual Protocol allows users to be undercollateralized.
This means that the value of a user’s collateral can be less than the value of their positions in perpetual futures. In other words, users can leverage themselves.
Perpetual protocol risk management
Perpetual protocol measures users’ risk by a ratio of their collateral to the value of futures positions. It calls it a margin ratio.
Margin ratio = collateral value / position value
A user is considered insolvent when the margin ratio is less than 6.25%. When this occurs, the user is liquidated.
Therefore, this is the indicator that we must monitor in order not to be liquidated.
On the other hand, Perpetual protocol has a mechanism to prevent the price of the future (mark price) from diverging too much from the price of the underlying asset (index price).
If there is a very large disproportion between users who have long positions (buy futures) on an asset and those who have short positions (sell futures), the price of the future will move in the direction in which there are more users, separating it from the price of the underlying asset.
To avoid this, Perpetual protocol introduces funding payments.
These are payments made by traders who move the price of the future away from the price of the real asset to traders who move it closer. They depend entirely on the funding rate.
Funding payment = funding rate * position value.
Funding rate = (mark price / index price) / index price.
For example, in the event that there are more users who buy futures of an asset than those who sell, they would push the price of the future above the price of the asset, resulting in a positive funding rate.
When the funing rate is positive, those holding long positions pay those holding short positions in the amount resulting from the formula.
In the opposite case, the funding rate would be negative and users with short positions would pay those with long positions.
Funding payments come out of the collateral of those who pay them and are added to the collateral of those who receive them. Therefore, it directly affects the creditworthiness of the users.
What you can do to avoid being liquidated
First, make sure your collateral has a stable value. Deposit stable currencies like USDC or USDT instead of volatile assets like ETH or OP.
At the same time, you should monitor your unrealized gains and losses as these add to and subtract from your collateral, directly affecting the margin ratio.
Secondly, you need to understand that the less leverage you use, the higher the margin ratio and the more fluctuations in the value of your positions you can withstand without being liquidated.
Finally, before buying or selling futures on an asset, examine the behavior of its funding rate to get an idea of what you might have to pay and monitor the value of the funding rate of your positions in case you need to add more collateral.
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