Bybit Learn
Bybit Learn
Aug 29, 2022

Top 5 Mistakes to Avoid When Trading Leveraged Tokens

A variety of financial instruments can help you gain leverage when trading crypto, but none of them are as simple as a leveraged token. This article helps explain the concept and offers advice on avoiding common mistakes when trading leveraged tokens in the crypto market.

What Are Leveraged Tokens?

Leveraged tokens are a financial product that tracks the price movements of an underlying asset. The tracking is done using derivative instruments to ultimately multiply your earnings.

Leveraged tokens are becoming popular because they let you trade with leverage without worrying about margin calls, liquidation risk and loans from your broker. In addition, you can trade them as easily as other coins.

3X Long Ethereum Token (ETH3L) is an example of a leveraged token. The "3X" indicates the leverage, which means that your assets are multiplied by three if ETH3L increases in value. However, it's a double-edged sword because you can also lose value quickly as well. For every 1% drop in ETH, ETH3L also decreases by 3%.

There are all kinds of leveraged tokens. For instance, if you're anticipating a drop in the price of ETH, you can buy a 3X Short Ethereum Token (ETH3S). In this case, ETH3S Token will give you three times leverage if the price of Ethereum starts to fall.

Depending on the crypto exchange, the trading symbol may differ slightly. Accordingly, here are a few other examples of leveraged tokens:

  • BTC3S: For every 1% decrease in the BTCUSDT price, the value of BTC3S will rise by 3%

  • ADA2L: For every 1% increase in the ADAUSDT price, the value of ADA2L will rise by 3%

  • GMT2S: For every 1% decrease in the GMTUSDT price, the value of GMT2S will rise by 3%

You may also come across leveraged tokens that have different margin ratios — for example, HALF (1/2X) and HEDGE (-1X).

How Do Leveraged Tokens Work?

Understanding the difference between a leveraged token and a derivative will help you appreciate the need to introduce leveraged tokens in the market.

Traditionally, investors have used derivatives to take leveraged positions in the market. In a way, this lets you open a much larger position than your account allows. To trade a derivative, you borrow funds from the broker. In this setup, you must keep an eye on margin requirements and the risk of liquidation because the position is based on borrowed money.

In contrast, leveraged tokens don’t require collateral. You can buy and sell a leveraged token as easily as any other cryptocurrency without worrying about liquidation and margin requirements.

A leveraged token manages liquidation risk using a dynamic rebalancing mechanism, which compounds profits. The profit is automatically reinvested into the underlying asset. Similarly, it sells some of the profit when the price drops. This rebalancing act nullifies any risk of liquidation.

Since you don’t borrow anything from the broker, there’s no need to worry about maintaining a specific margin.

The Rebalancing Mechanism

A leveraged token is like a crypto trading fund where investors keep their money. At the end of the day, the fund rebalances itself to maintain a target leverage exposure and ensure that there's no liquidation risk. This is known as the regular rebalancing mechanism. However, in the case of Bybit, the fund rebalances itself when the leverage hits -4X, -2X, 2X or 4X. This is referred to as an irregular rebalancing mechanism.

In the case of a 3X token, if the token is profitable on a given day it will reinvest its profits in the underlying asset. This is similar to compounding. If it has losses on a given day, it will sell off some of its positions to reduce its leverage back to 3X to avoid liquidation.

In extremely volatile situations, the leveraged token can also rebalance itself intraday. For example, it usually requires a 33% adverse move to liquidate a 3X token. If the situation demands it, the 3X token can perform an intraday rebalancing act when the price moves between 6% and 12% in the opposite direction. The intraday rebalancing helps reduce the risk of liquidation by returning the token to 3X leverage.

Top Mistakes to Avoid When Trading Leveraged Tokens

There’s little doubt that leveraged tokens are some of the most misunderstood products in the industry. While leveraged tokens are suitable for anyone willing to take the extra risk, there’s more to them than meets the eye.

If you want to trade leveraged tokens, avoid these top 5 common mistakes.

Holding Leveraged Tokens Long-Term

Leveraged tokens are not intended for long-term investment. Instead, they're more suitable for short-term investment and trend-trading. Holding them for long periods will expose you to greater risk.

Why Do Traders Make This Mistake?

It's quite common for crypto traders to ignore the basic math associated with leveraged tokens. For instance, in the event of consecutive losses, a leveraged token needs a return greater than its loss to break even.

Impact of Holding Leveraged Tokens Long-Term

If you're holding a leveraged token long-term, be sure you understand that it will behave poorly as compared to a typical margin position. If a 3X leveraged token loses 10% daily for three days, the total loss is 90% (30% x 3 = 90%). In other words, you’ll require a 1,000% return to recover that loss.

What Should You Do Instead?

In the event of consecutive losses, actively monitor your account, cut losses quickly and control risk exposure.

Neglecting the Effects of Volatility Decay

Volatility decay is the accumulated decrease in the P&L portfolio of an investor due to the frequent ups and downs in the market. Since markets are non-trending in nature, you need to consider volatility decay when trading leveraged tokens.

Why Do Traders Make This Mistake?

When trading leveraged tokens, most traders don't take volatility decay seriously because they're used to trading typical financial instruments. As a result, it's surprising for them when their leveraged token underperforms despite a slight uptick in the market.

Impact of Neglecting the Effects of Volatility Decay

As discussed, a typical 3X leveraged token will perform well in a trending market because there is no volatility decay. However, it can misfire in fluctuating markets.

Suppose you invest $100 in a crypto which gains 10% on the first day and loses 10% the next day. In this case, the value of the 3X leveraged token is $130 on the first day because it gained 30%. The following day, the value will decrease to $91 because the price was reduced by 30% ($130 − 30% = $91).

If you were to hold a normal crypto account, it would perform better because it reached $110 the first day, and finished up 10% lower at ($110 − 10%) = $99 the next day.

What Should You Do Instead?

Theoretically, there’s not much you can do to avoid volatility decay because it's an intrinsic part of any leveraged financial instrument. To prevent such risks, it's recommended you trade leveraged tokens when markets are trending and nonvolatile.

Disregarding the Effects of Rebalancing

A leveraged token rebalances its portfolio either at the end of the trading day or once the leverage hits -4X, -2X, 2X or 4X. New traders often disregard the rebalancing mechanism.

Why Do Traders Make This Mistake?

A lot of new traders fail to see leveraged tokens as a portfolio that must maintain its leverage at each stage. They forget that if tokens are held for a very long period, the continuous rebalancing act will ultimately lead to losses.

Impact of Disregarding the Effects of Rebalancing

A leveraged token increases or decreases its exposure according to the rise and fall in the value of the underlying asset.

In an ideal scenario of irregular rebalancing, when you're trading in a trending market or you're holding the token for a couple of weeks, there will be fewer instances of rebalancing.

In the long run, the token is exposed to various volatile market conditions that can trigger multiple rebalancing acts. Therefore, investors holding the token for an even longer period of time may experience a dramatic rise or fall in their investment.

In an ideal scenario of regular rebalancing where rebalancing happens at the end of the day, there will be fewer rebalancing acts when you hold the token for just a few days.

However, over the course of a few days, the various volatile market conditions can potentially trigger multiple rebalancing acts, resulting in token holders experiencing sharp increases or decreases in their investment.

What Should You Do Instead?

To avoid risk, only hold a leveraged token when you're sure that the market will trend in a certain direction. In this scenario, you're likely to experience exceptional returns without facing adverse conditions.

Letting Losers Run

Risk management and control are essential for successful trading. In adverse trading conditions, it's wise to close your losing positions when necessary.

Why Do Traders Make This Mistake?

Most new traders don’t change their style when trading leveraged tokens. They often let losers run, waiting for the momentum to turn in their direction. While this holding pattern is justified for long-term investments in traditional markets, it can quickly doom your investment when trading leveraged tokens.

Impact of Letting Losers Run

When trading leveraged tokens, the impact of loss is magnified because you require greater returns to recoup your losses. To understand this phenomenon, let's run a comparison between a normal account and a 3X leveraged account.

In a typical account, which experiences a 10% loss for three consecutive days, you’ll see a 30% decline in your portfolio. Using $1,000 as an example, a loss of 30% will result in your having $700 left. In order to recoup the 30% loss, you would need a return of 43%. This isn't the case with leveraged tokens.

When trading 3X leveraged tokens (as explained above), you need a return of 1,000% in order to recoup 90% (30% loss daily x 3 = 90%) of your losses. Accordingly, it will take more effort to regain your initial investment.

In an event of losses, a leveraged token needs a return greater than the loss to break even.

What Should You Do Instead?

If you're not sure about the trend or the future direction of the market, try to hedge your position during adverse conditions.

Not Using Trend Trading

Trend trading is designed to take advantage of market trends. It's based on the idea that markets have an element of predictability that allows traders to accurately predict price movements in the short run. Some traders ignore the existing trend, which can ultimately lead to a loss.

Why Do Traders Make This Mistake?

When trading leveraged tokens, it's common for investors to rely on long-term fundamentals. However, this mindset isn’t conducive to trading leveraged financial instruments. Instead, leveraged tokes are better suited to swing trades and intraday trades.

Impact of Not Using Trend Trading

If you're not using trend trading, your leveraged positions are exposed to risks from price fluctuations, volatility, rebalancing and transaction fees. The negative impact of these elements offsets any gains you're likely to enjoy.

What Should You Do Instead?

Try to trade during a trending market. You can either wait for the confirmation of the trend, or enter a market when there’s a high probability of a breakthrough. In any case, stay away from a ranging market because it's counterproductive.

The Bottom Line

Leveraged tokens are designed to take advantage of short-term trends in the market. If used as intended, leveraged tokens can quickly offer tremendous gains in a very short time span. They're simple and extremely effective.

Despite their attraction, they’re not for the faint of heart. Therefore, before trading leveraged tokens, avoid common mistakes by having both risk-mitigating trading strategies and an exit plan.