"Investigation: I don't understand contract trading, is it feasible to trade 'leveraged tokens'?"

The leveraged contract trading market is hot, and for those who have no experience in derivative trading, a new product called "leveraged tokens" has emerged in the market, simplifying the complex details of contract trading operations. It is similar to leveraged ETFs, with its own advantages and disadvantages.

Preface

Cryptocurrencies have been in operation for over 10 years since the birth of Bitcoin. The trading mechanisms have become more robust, sophisticated, and increasingly diversified. Bitcoin trading initially started with exchanges between programmers, like the well-known Bitcoin Pizza Day (exchanging 10,000 bitcoins for 2 pizzas). It wasn't until the emergence of exchanges that cryptocurrency trading entered a stage of standardization and scalability.

Looking at the current cryptocurrency market, spot trading is no longer as active as before. We observe that mainstream cryptocurrency exchanges are increasingly involved in derivative trading markets. Traditional financial institutions like the Chicago Mercantile Exchange (CME) and Bakkt under the Intercontinental Exchange (ICE) have also started offering Bitcoin derivatives to institutional investors. A recent report from financial giant JPMorgan highlights the involvement of compliant exchanges in cryptocurrency derivative trading, indicating that this market is gradually maturing and attracting institutional investors.

However, cryptocurrency futures, options, and other derivative products often come with high leverage multiples, acting as a "double-edged sword." While many traders benefit from high leveraged returns, there is also the potential for losses several times over, even leading to the loss of assets. Operating derivative products allows retail investors to potentially gain high returns with small capital, but for the younger investment generation who are not familiar with derivatives, the learning curve is higher due to the complexities involved, such as margin requirements, funding rates, and choosing leverage ratios.

Given this background, is there an investment target that allows participation in leveraged trading of derivatives like buying and selling spot assets without the need for margin and without much knowledge? The newly emerged "Leveraged Tokens" in the market seem to meet this demand, but are there potential pitfalls behind them?

What Are Leveraged Tokens?

This product was first introduced in 2019 by FTX and has since been listed on exchanges like Binance, BitMax, and Pionex, with tokens sourced from FTX, resulting in similar design across platforms. Leveraged Tokens are virtual currencies (following the Ethereum ERC-20 standard) that tokenize leveraged trading, allowing users to trade without the need for margin and with the benefit of 3x leverage.

The specific advantages are as follows:

• Risk Control: When facing losses, leveraged token funds automatically reduce positions to avoid liquidation risks.
• Simplified Margin Trading: It allows trading similar to spot trading without the complexities of margin trading.
• Automatic Leverage Adjustment: It automatically maintains leverage ratios to effectively increase profits.

A set of leveraged tokens typically includes three types of tokens. Taking Bitcoin as an example:

• BTCBULL: 3x leveraged token for long BTC positions
• BTCBEAR: 3x leveraged token for short BTC positions
• BTCHEDGE: 1x leveraged token for hedging

In simple terms for BTC leveraged tokens, when BTC rises by 1% in a day, BTCBULL will rise by 3%; when BTC falls by 1%, BTCBULL will fall by 3%, while HEDGE will fall by 1%; BTCBEAR will do the opposite.

The above is a simple concept of price fluctuations within a day, but it is more complex in reality.

How Do Leveraged Tokens Actually Work?

Leveraged tokens offer 3x leverage on price movements, linking their prices to perpetual futures contracts on exchanges. For example, if the volatility on the perpetual contract on day 1 is M1, day 2 is M2, and day 3 is M3, the formula for 3x leveraged tokens is as follows:

Latest Price = Previous Price * (1 + 3*M1) * (1 + 3*M2) * (1 + 3*M3)

Price Fluctuation Percentage % = Latest Price / Previous Price - 1 = (1 + 3*M1) * (1 + 3*M2) * (1 + 3*M3) - 1

To compare how users fare when "managing futures leverage trading on their own" versus "using leveraged tokens," let's explore the differences:

"Managing Futures Leverage Trading on Their Own": Assuming BTC's initial price is $9,000, on day 1, the price is $9,450 (a 5% increase), and on day 2, it's $9,900 (10% increase); with 3x leverage trading, settling at $9,900 results in a 30% profit.

"Using Leveraged Tokens": If we use BTCBULL as an example, ideally, it would yield higher profits. Plugging in BTC perpetual contract prices and volatility into the formula results in:

Price Fluctuation Percentage % = 1 + 3*M1 * 1 + 3*M2 = 15% * 14.3% = 31.4%

This means that buying BTCBULL at $9,000 and experiencing a 10% increase over two days would result in a profit of 31.4%, higher than the 30% from self-managing a 3x leveraged position.

According to the formula, in a market with consistent trends over several days, leveraged tokens offer returns similar to compound interest. Therefore, compared to the 3x leveraged long positions in the futures market, leveraged tokens can potentially yield higher returns.

Are There No Pitfalls? It's Only Suitable for Short-Term Consistent Trends

Taking BTCBULL as an example, here is a calculation table for different market trends:

During continuous uptrends, there are relatively higher returns, and during continuous downtrends, there are rules in place to automatically reduce positions (decreasing assets in the wallet) to minimize losses.

The rules involve a "rebalancing mechanism" adjusted daily at fixed times based on price fluctuations. This mechanism seems to be the most significant convenience that leveraged tokens bring. When consistently profitable, it maintains a 3x leverage for traders to earn compound interest. In a continuous loss scenario, it gradually reduces positions for investors to prevent liquidation.

Note: However, under special circumstances, there is still a risk of liquidation. If the perpetual futures contract experiences daily fluctuations exceeding 33%, it may lead to asset liquidation. Also, when the perpetual contract fluctuates by 10%, it will automatically rebalance to reduce risks and restore to 3x leverage. In simple terms, it reduces the risk of losing everything. Additionally, the "management fee" similar to funding rates in futures contracts is a variable cost to be mindful of.

However, "earning more and losing less" only occurs during short-term consistent trends. According to observations from the Deribit exchange, whether it's a bullish or bearish leveraged token, in multi-day price fluctuations, "losing more and earning less" outcomes may occur.

Let's first look at the example of ETH leveraged tokens (ETHBULL / ETHBEAR):

The calculation table above observes market price changes over five days (from increase to decrease) comparing the returns between "ETHBULL (3x leveraged long ETH tokens)" and "directly operating 3x leveraged long ETH contracts."

It can be seen that on the first and second days, with ETH price dropping from 100 to 80 over two consecutive days, due to the rebalancing mechanism, ETHBULL automatically reduces positions to cut losses to 53%, compared to a 60% loss from directly managing 3x leveraged ETH contracts, achieving the function of losing less.

However, from the third to the fifth day, as the market starts to rise continuously from 80 to 125, a situation of "earning less" occurs. Due to the previous rebalancing, when transitioning to profits, the position is smaller, and it lags behind the profits from directly operating contracts. Therefore, by the fifth day, the final profit for ETHBULL is 51%, less than the 51% from operating contracts.

While earning less is acceptable, the possibility of losing more may not be desirable for investors.

Following the logic of ETHBULL, situations of "losing more" can also occur. The example above compares "ETHBEAR (3x leveraged short ETH tokens)" with "directly operating 3x leveraged short ETH contracts," showing that when prices shift unfavorably (from increase to decrease), leveraged tokens result in greater losses (-76% compared to -75% from operating contracts). This phenomenon is also seen in the ETF (Exchange-Traded Fund) market, known as Beta Slippage - volatility decay.

Are There Differences Among Different Exchanges?

Many exchanges have listed leveraged tokens for different cryptocurrencies, with the tokens sourced from FTX exchange.

When trading leveraged tokens on various exchanges, the trading fees are the same as spot trading fees. Additionally, a daily "management fee" is charged (FTX charges 0.03%), usually deducted from the net asset value of the leveraged tokens, not directly visible in the account balance. Therefore, some exchanges may not explicitly mention this fee:

Conclusion

The cryptocurrency market is known for its high risk and volatility, often leading seasoned traders to advocate for "spot trading is king" to emphasize the risks of derivative trading. Despite this, many investors are not satisfied with spot trading and enter the derivative trading market seemingly unfazed by risks.

Taking leveraged tokens as an example, they are essentially suitable for users transitioning from spot trading to futures and other derivative markets. However, if users lack risk awareness, hold positions for too long, or engage in poor trading habits, even with the safeguards of leveraged tokens, their assets may have significantly decreased after trading.

Quoting a statement from Deribit's research: "Investors should note that the performance of leveraged tokens depends on market paths and requires constant vigilance. Once they start gaining popularity, they are likely to become targets for specialized traders."

In general, leveraged tokens are only suitable as a tool for short-term trading or as a stepping stone before attempting futures trading. Cryptocurrency derivatives entail high risks, and among all risk factors, "controllable risk" is almost entirely in the hands of traders. Therefore, as cryptocurrency derivatives become more popular, managing risks and finding the right trading products tailored to individual needs becomes crucial.