As cryptocurrency investing has evolved, new types of tradable assets have become available. One that has gotten the attention of investors with a high risk tolerance is leveraged tokens.
A leveraged token allows you to take a leveraged position in a cryptocurrency, meaning your earnings or losses are multiplied. For example, a token called 3X Long Ethereum Token (ETHBULL) triples the profits of an Ethereum investment. So if Ethereum increases by 1%, ETHBULL’s value increases by 3%. It works the same way if Ethereum decreases in price.
People often buy leveraged tokens without fully understanding how they work. To avoid an investment you’ll regret, there are several things to know before you buy.
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1. Leveraged tokens rebalance to maintain a target leverage
Each leveraged token has a target leverage, such as three times the underlying asset. To maintain that leverage, the token will rebalance automatically. If it makes money, those profits will be reinvested. If it loses money, it will sell some of its position.
Leveraged tokens typically rebalance every day. The exchange that offers the token may also have triggers that cause it to rebalance as soon as possible during periods of high volatility.
Note that leveraged tokens with the Binance exchange work a bit differently. Instead of a specific target leverage, they have a target leverage range. For example, some Binance Leveraged Tokens have a target leverage range of 1.25 to four times the price of the asset.
2. They’re popular for their simplicity
Margin trading is usually complex and requires active management on the investor’s part. Leveraged tokens, on the other hand, are a simple alternative that don’t require you to do anything.
There’s no collateral or margin (money borrowed from a brokerage or crypto exchange) to worry about. The risk of liquidation is very low because of rebalancing. Even if the token drops in value, it will sell off some of its position, making it unlikely that it will be wiped out.
3. They’re susceptible to volatility decay
One of the biggest risks of leveraged tokens is volatility decay, or the negative impact of volatility on the investment. The best way to understand this concept is with a comparison.
Let’s say you’re interested in buying Bitcoin, so you purchase $100 of it. After a day, the price has increased by 10%, and your investment is worth $110. But the next day, the price decreases by 10%, which would be an $11 drop. Your investment would be worth $99.
What if you invested $100 in a leveraged token that tripled Bitcoin’s returns? That would turn the 10% increase on day one into a 30% increase, bringing your investment up to $130. But it would also result in a 30% drop on day two, costing you $39 and leaving you with $91. A minor loss on a normal crypto purchase becomes a much bigger loss on a leveraged token.
Even with smaller back-and-forth price movements, volatility decay eats away at your investment.
4. Many crypto exchanges don’t sell them
Buying leveraged tokens can be a process, especially for U.S. residents. They’re only listed on select cryptocurrency exchanges, and some of these exchanges don’t let you deposit cash.
So, how can you buy leveraged tokens? A popular method is to use another crypto exchange as an “on-ramp” to deposit money, and then transfer those funds to the exchange that sells leveraged tokens. Here’s how this would work:
- Deposit money to an exchange that allows it, such as Coinbase.
- Use those funds to buy a cryptocurrency you’ll transfer. Stablecoins, such as USD Coin (USDC), are a common choice.
- Transfer your crypto to an exchange with leveraged tokens, such as KuCoin or Gate.io.
Once that’s done, you can trade the crypto you transferred for leveraged tokens.
Volatility decay is one issue with holding leveraged tokens. Another is that they usually have additional management fees. Here are management fees for two popular types of leveraged tokens:
- Binance Leveraged Tokens have a daily management fee of 0.01%.
- FTX Leveraged Tokens have a daily management fee of 0.03%.
Those may seem small because they’re daily rates, but consider how much they would cost you over the course of a year. Binance Leveraged Tokens would cost 3.65%, and FTX Leveraged Tokens would run up management fees of over 10%.
6. They’re short-term investments for advanced traders
Because of volatility decay and management fees, leveraged tokens aren’t a long-term investment. Cryptocurrency is volatile, so if you’re holding on to leveraged tokens, there’s a strong chance of losing money.
These are primarily investments to make if you’re confident the underlying cryptocurrency will rise or fall in price soon. By purchasing a leveraged token, you can dramatically boost your profits — assuming you’re correct on which direction the token goes.
The risk involved also means that leveraged tokens aren’t beginner friendly. You can lose a significant portion of your investment very quickly.
For most investors, it’s better to buy and hold cryptocurrencies. They’re already volatile enough without adding leverage that amplifies every price movement. If leveraged tokens are something you’re interested in, spend plenty of time researching them first and only put in money you’d be comfortable losing.
View more information: https://www.fool.com/the-ascent/cryptocurrency/articles/6-things-to-know-before-you-buy-leveraged-tokens/