How Leverage Tokens Perform in Different Market Conditions

While Index Coop leverage tokens offer a simple way to gain amplified exposure, they can also perform in counter-intuitive ways. Borrowing costs, compounding, price impact, and trading fees can all contribute to volatility drift and affect the performance of leverage tokens. 

It’s critical that users of leverage tokens understand how they tend to perform so that they can make informed decisions about their leveraged positions. With that in mind, in this article we’ll take a look at how ETH2x performs in three different market conditions: a persistent uptrend, a persistent downtrend, and a volatile market. 

How ETH2x Performs in an Uptrend Market

To understand how ETH2X operates in different market conditions, we’ll look at its performance against both an ETH 2x Leveraged Perpetual Futures (Perp) and the base asset, Ethereum (ETH).

In a market characterized by a mild uptrend, the ETH2X and a 2x leveraged perpetual futures contract might appear to move in tandem. Both are designed to capture twice the movement of ETH's price. However, when ETH ascends steadily, because the Perp doesn’t rebalance the way ETH2x does, it underperforms ETH2x. 

As the price of ETH surges, the effective leverage of both instruments naturally decreases because the value of the underlying collateral increases alongside the net asset value. Unlike the Perp, which may continue to experience diminishing leverage, the ETH2X will rebalance to maintain its target leverage level, thus potentially capturing more of the uptrend.

Over time, as ETH's price skyrockets, the Perp's effective leverage diminishes, dampening the expected returns. In contrast, ETH2X hits its lower leverage bound and rebalances to capitalize on the upswing. 

How ETH2x Performs in a Downtrend Market

As the value of ETH falls, the ETH2X's leverage ratio increases, amplifying the exposure to downturns. To mitigate risks, the product automatically deleverages. While this can protect against the full brunt of a decline, it also means that the product may not capture as much of the upside if a swift market recovery occurs. 

This is also the same mechanism that protects users from liquidation. If the leverage ratio increases past a certain point, the position would be liquidated. By deleveraging, users are provided liquidation protection they can’t get when using Perps. 

This chart shows a backtest of ETH2X versus the Benchmark. In this case, the benchmark is the Daily Rebalancing 2x Index with no rebalancing costs. Although the two are highly correlated, the ETH2X will lose value over time due to rebalancing costs and non-perfect 2x leverage. This difference is known as “tracking error” and the range-bound methodology seeks to minimize it as much as possible by making trade-offs between rebalancing frequency and the tightness of the leverage bounds.

The last chart we will look at is the ETH2X vs. Perp 2x Backtest which illustrates how leverage tokens outperform in a bull market and underperform in a bear market, especially when held for longer periods of time. Note, that when the price of ETH is declining, ETH2X moves down more sharply, but when the price of ETH is increasing ETH2X increases faster than the Perp. To be clear, this chart oversimplifies a bit because it does not account for the cost of carry in ETH2X and the often exorbitant funding rate costs for perps.

‍How ETH2x Performs in a Volatile Market

In a volatile market frequent and sharp price movements can lead to more rebalancing events, which may erode the potential benefits of leverage due to volatility drift. This environment poses a higher risk and requires cautious engagement with leveraged products like ETH2X.

In highly volatile markets with no clear trend, the performance of ETH2X can suffer significantly from volatility drift. Frequent and significant market swings in both directions can trigger repeated rebalancing, leading to a scenario where the compounded returns stray from the intended 2x target.

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How to use ETH2x tokens 

As we've navigated the complexities of leverage and volatility drift, it's clear that the strategic use of ETH2X by holders hinges on understanding market conditions and holding timeframes.

ETH2X tends to perform best in stable or predictably trending markets, where leverage can be maintained without frequent rebalancing. People looking to capitalize on a steady uptrend will find ETH2X to be a valuable tool, as it's designed to provide sustained leverage, amplifying the potential gains without the need for daily management.

The length of time users plan to hold a leveraged position is significant. Given the nature of volatility drift, ETH2X is typically more suitable for short-term horizons—days to weeks—where the effects of volatility are less pronounced. Over longer periods, the impact of rebalance cost, volatility drift, and cost of carry can lead to significant divergence from the expected 2x returns of the underlying asset, especially in volatile markets.

Index Coop's leveraged products come with built-in safeguards, such as automated liquidation protection, which can help prevent the total loss of the position in the event of extreme market movements. This feature is particularly important for less sophisticated holders who may not be actively managing their positions.

Users should consider their risk tolerance, objectives, and the prevailing market conditions before entering into leveraged positions with products like ETH2X. It's also vital for users to stay informed about the potential impact of volatility drift on their holdings and to regularly reassess their positions in light of market movements.

Understanding the prevailing market trend is crucial when holding leveraged products like ETH2X. A strong uptrend or downtrend can significantly affect the performance of these products, and recognizing these trends early can guide your decisions.

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