In order to understand how inverse tokens such as BTCSHORT works, it is important to first understand the risks of holding tokens which use leverage and tokens seeking daily leveraged performance (e.g. -1x), as well as being comfortable with actively monitoring your holdings in tokens. This is because BTCSHORT is designed to be held for a period less than or equal to 1 day. These tokens are not suitable for long term holdings. In this post, we exclude all fees and expenses associated with BTCSHORT and holdings of Bitcoin.
Understanding compounding is key to ensuring that you are able to appropriately handle the risks associated with holding BTCSHORT. The token resets (or rebalances) at the end of each day. As such, yesterday’s change in value contributed to the rebalancing at the start of the next day — as BTCSHORT aims to maintain a -1x notional exposure to the daily percentage change in the value of Bitcoin. Because of this, compounding can significantly increase or decrease a token holder’s -1x exposure to Bitcoin if BTCSHORT is held for more than 1 day. We will show three scenarios where this is the case.
Scenario 1 — High Volatility, Stable Bitcoin Price
BTCSHORT will underperform in a volatile market. As mentioned, BTCSHORT tracks -1x the daily performance of Bitcoin. If the price of Bitcoin falls and therefore the token’s value rises on day one and then is followed by a rise in the price of Bitcoin the following day of the same percentage, the loss suffered by the Token will be applied to a larger amount than the gain the previous day. This means the token will have lost value even if the price of Bitcoin ends up being the same after two days. In a similar fashion, If the price of Bitcoin rises and therefore the Token’s value falls on day one and then is followed by a fall in the price of Bitcoin the following day of the same percentage, the gain enjoyed by the Token will be applied to a small amount than the loss of the previous day. This means the token will have lost value even if the price of Bitcoin ends up being the same after two days.
Volatility has a negative effect on token holders who hold the token for longer than a day as the table and graph below shows.
Scenario 2 — Low Volatility, Downtrending Bitcoin Price
If the Bitcoin price is stable but trending in a negative direction, then BTCSHORT’s value will benefit. This is because daily returns of the token are compounded and gains made on one day will benefit from gains made on previous days.
As you see, BTCSHORT outperforms the non-compounding index by 0.18% as compounding benefits inverse tokens in a low volatility market with a consistent trend.
Scenario 3 — Low Volatility, Uptrending Bitcoin Price
If the Bitcoin price is stable but trending in a positive direction, then BTCSHORT’s price will suffer. Losses made on one day will be subsequent losses applied to a smaller amount. This means that compounding will lead to slightly reduced losses than if there were no compounding.
BTCSHORT performs less worse than what it would have done if there was no compounding as we can see by the fact that BTCSHORT falls less over two days than Bitcoin rose in absolute terms. Compounding greatly affects the performance of BTCSHORT over periods longer than one day. This effect is particularly noticeable in volatile markets. As such, BTCSHORT has a holding horizon of less than or equal to one day and holders should consider their holdings at least daily.