Moon and Doom: How do Leveraged Tokens Work?

By now most of you have probably heard of FTX, the new cryptocurrency derivatives exchange launched earlier this year. They’ve launched a whole bunch of new and interesting indices, contracts and features that would be considered commonplace in traditional markets, but are still novel to the nascent crypto trading community. In this article, I’ll be covering the Bull, Bear, Moon and Doom leveraged tokens in the hope that you’ll be able to understand a bit better how they function both from a technical perspective, and as a potential addition to your portfolio.

So what’s a leveraged token?

In this article, I’ll be using the example of a 3X leveraged long token on Bitcoin (ticker symbol BULL) for ease of reference. So in this case, the token is an ERC20 token issued by a smart contract on the Ethereum blockchain, which represents a 3X long position on Bitcoin.

While this sounds simple, there’s a bit more to it than that. In order to understand how the token differs from an actual 3X long position (and what some of the benefits/drawbacks are), we’ll have to dig into the technical side on how the token is managed.

Creation and redemption

To create a BULL token, a customer has to visit the FTX page and deposit the current value of the token. The exchange would then work some magic on the backend, and the smart contract would issue one BULL token to your exchange wallet.

The same process may be used in reverse to redeem your token, which helps ensure that the price of the token aligns properly with the price of the underlying asset.

Algorithm management

That magic on the back end I mentioned involves an algorithm which manages funds to automatically keep the price of the token in line with the percentage gain (or loss) on Bitcoin, multiplied by three on a daily basis. I emphasize daily basis, because the algorithm’s job is quite difficult and it has to maintain some parameters in order to function properly. One of those parameters is choosing a timeframe over which to emulate performance.

A 3X long token which aims to replicate the effect of a 3X long over the period of a year functions differently than one aiming to replicate the effect of the same over one day. The FTX tokens are all designed to emulate performance over a 24 hour period, otherwise known as the rebalancing period.

Let’s use an example before this gets too complicated. Let’s say both BULL and Bitcoin are trading at $10,000. If the price of Bitcoin increases to $11,000 in the period of a day (+10%), the BULL token should reflect that increase, magnified by 3X, meaning it should trade at $13,000 (+30%). So far so good. But what happens if price drops by the same amount?

Using our previous example, if BTC price drops by 20% instead of gaining, the price of BULL should drop by sixty percent to $4,000. But this causes an issue, since the BULL token is a leveraged token. We are now much closer to the point of liquidation with only another 10% drop in spot before the token’s collateral should be liquidated. In order to handle this, the algorithm reduces leverage and exposure to the market. This can happen intraday (in between rebalancing periods), and the conditions for this are a bit complicated. You can read the official documentation here, but for now the important part is that the algorithm will do its best to ensure that the position is never liquidated, and continues to hold some level of value (even if it’s much lower than before).

Again, not too difficult to understand. The primary differences between a leveraged token and a leveraged long position are beginning to show though. Since the algorithm is managing margin, the token itself is highly unlikely to ever be liquidated (this would only happen in market conditions which move so suddenly and violently that the algorithm does not have time to deleverage). So even if spot price drops by more than 33% (the usual liquidation point for a 3X long position), the token will maintain value as long as the algorithm can keep up. But now we come to the largest and most misunderstood difference between a leveraged long and a leveraged token.

Intra-day decay

We know that the tokens rebalance every 24 hours (at 02:00 UTC to be precise). So what happens when we get a large downswing in spot price at the beginning of the day, say -10%, and then finish the day up 5%?

This is where the leveraged token may not perform the same way that a leveraged long would. Whereas a leveraged long would maintain a linear correlation (3:1) with the spot price, a leveraged token may differ because of the auto-rebalancing. If the spot price drops by 10% and the algorithm is forced to reduce leverage in order to maintain token value, when the upswing comes later in the day, it will not be able to fully capitalize on that upswing because the token is “under-funded”. Again, this is necessary in order to avoid liquidation, but may catch some traders off-guard. The token will re-balance at 02:00 UTC in order to capitalize on moves for the next day (or if the token becomes 33% over-leveraged, which is rare), but will not have performed as well as a 3X leveraged long on spot or futures for that day only.

Compounding positions

To counteract this though, there are some very helpful benefits to trading the token as opposed to a typical long position. We’ve already covered the fact that the token is incredibly unlikely to be liquidated, but a second advantage is that due to the daily rebalancing, as long as price trends in your favor for multiple days, your position will automatically compound.

In our earlier bullish scenario, the token would end the day up $13,000 from $10,000. However on the next day, let’s say spot price increases by another 10% from now $11,00 (+$1,100) to a total of $12,100.

While a 3X long would simply be up 60%, or $6,000 (3X a total of a 20% move), the leveraged token has rebalanced. So on day one it is up $3,000 just like the margin long, but on day two, it is up 30% from the beginning of that day, not the day previous. So on day two, the token gains 30% on $11,000, or $3,300 for a total gain over two days of $6,300. This of course out-performs the margin long position by $300.

So how does this help me as a trader?

Leveraged tokens are a fantastic tool in several aspects. If you don’t want to have to worry about liquidation on your positions, these tokens can provide some peace of mind. They are also much better during strong trending periods, due to the daily rebalancing and compounding effect, which would otherwise need to be done manually in order to achieve the same result. Another advantage is that as ERC20 tokens, they can be stored offline in your cold wallet, giving you full control over your funds, though it’s best to avoid holding them for long during a period of mean-reversion or ranging action due to the possibility of deleveraging.

Though based on spot pricing, some systemic or algorithmic traders may also find these tokens to outperform on low timescales as trading instruments, simply due to the artificially increased momentum which these tokens can display.

Final thoughts

While I’ve only used the BULL token as an example in this article, each of the BULL, BEAR, MOON, DOOM and HEDGE tokens function in the same way, with varying directional bias and leverage applied. For more detail on how these tokens work, I encourage users to read the full documentation found here.

Thanks for reading!

If you learned anything or found this article valuable, please leave it some claps (up to 50!), share it on Twitter and other social media and leave a comment! It really helps with visibility. For more like this, follow me here and on twitter!

Disclaimer: I was not solicited or paid in any format for this article. I hold no exposure to the FTT token, as an American citizen I am prohibited from trading on FTX and all information contained in this article was provided via official product documentation. This article is not financial advice or an endorsement of any of the financial products discussed within.

I Draw Charts (David Holt)

Written by

I write about trading, investing and cryptocurrency. Contact IDrawCharts@protonmail.com

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