Should You (or Anyone) Buy Leveraged Tokens?

The idea of multiplying your returns may sound tempting. Multiplying your losses, not so much.

Leveraged tokens are one of many hybrid investment products the cryptocurrency industry has spawned in recent years.

They are also unpopular with financial authorities, who worry about the high level of investor risk. As a result, Binance announced in July that it would cease trading leveraged tokens across Europe, starting in the Netherlands, Germany, and Italy.

So what are these tokens and should you buy them?

What are leveraged tokens?

In investment, leverage, or buying on margin, is a way to magnify your returns (or losses) by essentially borrowing money.

Leveraged tokens let crypto traders access leverage without having to deal with more complex aspects of trading like collateral or liquidation. Liquidation is where the losses incurred by a margin trader are bigger than their investment, so the platform sells the position. Leveraged tokens reduce the risk of liquidation through a method of rebalancing, which we'll discuss below.

Not only can investors multiply the returns on their trades, but they can also bet on the price going down (shorting) or going up (going long). These are complex products, but they are also ordinary tokens on the blockchain that can be bought and sold. The way they are managed and the names of the tokens vary from platform to platform.

For example, an investor might buy ETHBULL, a 3x long Ethereum token on FTX. There's a similar token on Binance called ETHUP, which offers up to 4x leverage. Both work slightly differently.

What you need to know about leveraged tokens

Leveraged tokens appear easy to use, but they are still complex products. Here are some things you need to know before buying leveraged tokens.

1. Rebalancing can have a big effect on the price

Rebalancing is the way these tokens are programmed to automatically increase or decrease their positions to maintain the target leverage and avoid liquidation.

So, for example, if the price of Ethereum (ETH) changed, the ETHBULL token we mentioned earlier might need to buy or sell ETH to maintain its 3x position. It's a bit like a trading bot that responds to preset conditions.

Many tokens rebalance daily, which means that at a set time they buy or sell to increase or decrease their leverage. Tokens can also rebalance automatically if there's a dramatic change in the asset's price. It's important to understand how and when your token might rebalance, as it works differently on different exchanges.

2. Leveraged tokens are short-term investment products

If you buy and hold ETH and the price increases over time, you'll make a profit -- no matter what happens to the market on a day-to-day basis. But if you buy and hold an ETHBULL token, you'll magnify the impact of any price movements, which could prove costly.

To give you an example, let's look at the difference between holding $100 of ETH vs. $100 of 3x leveraged ETH across four days of trading.

As you can see, even after that 20% price increase on day four, magnifying those losses made it extremely difficult for the leveraged token to come out ahead. This is called volatility decay, and it's more extreme with a volatile asset like cryptocurrency.

3. You'll pay fees

Another reason to treat leveraged tokens as short-term investment vehicles is that you will pay daily management fees. These may not seem huge (Binance charges 0.01% a day, and FTX charges 0.03% per day), but they can add up. That would come to 3.65% for a year on Binance, and over 10% on FTX.

Should you buy leveraged tokens?

If you're considering buying leveraged tokens, you need to fully understand how they work and what the risks are. These are advanced trading products designed for more experienced investors. There's a reason Binance labeled them as the "most misunderstood products in the crypto industry."

Not only do you need to know the ins and outs of leveraged tokens, you also need to be clear on how rebalancing works on the platform you plan to use. For example, Binance leveraged token investors lost significant amounts of money when the crypto market suffered dramatic losses in May. Even though investors had gone short and bet on the price drop, the rebalancing system meant their tokens still lost value.

Another issue for U.S. investors is that it isn't easy to buy leveraged tokens. Most top U.S. cryptocurrency exchanges don't sell them. And if you use an unregistered exchange, be aware that it carries additional risks.

Trying to play the market through short-term trading is always more challenging than making long-term investments. And leveraged tokens -- a sort of turbocharged short-term investing method -- compounds an already risky and volatile asset.

For many investors, a better approach is to take time to research currencies you believe will perform well in the next five to 10 years. If you take a long-term perspective and only invest money you can afford to lose, you won't lose sleep over daily fluctuations in price.