This week I announced to my Crypto Rider and up subscribers that I had closed out my ETH 2x position and sold into regular ETH. I don’t think that the ETH run is over at all, but I had reason to worry about some irregular movement.
Let me explain the problem in two images. Here’s the fun one.
Yep, over the last month, my 2x ETH position has returned almost 93% while ETH has returned just 43% — meaning I had actually returned better than 2x ETH’s movement over the same time frame.
Now here’s the problem image.
You’ll notice that when ETH was soaring back in May of 2021, its 2x position hit $403, while now that ETH has eclipsed its previous high, the 2x coin is only at $221.95.
How is that even possible? How does the underlying coin go to new heights but the leveraged coin (the 2x coin) only make it back halfway?
The answer turns on the effects of average periodic rebalancing, which is used to calculate the leveraging of the coin. It affects all such leveraged products and it was the first real problem I had to solve when I was trading leveraged stocks for myself.
How You Can Leverage Crypto Trades
What I’m going to do with this lesson is explain three points:
- How price compression like the kind in the second image occurs.
- How I, in outline, solve this problem.
- What you might do if you wanted to try something similar.
As a preparatory note of clarification, what I’m talking about here is the trading of leveraged coins, not borrowing from your exchange at 2x and buying ETH. If you borrow, you’ll have to worry about liquidation if your collateral falls below a certain amount.
With leveraged coins, you never need to worry about liquidation. The risks are spread around a bit so that you instead need to worry about significant price crashes. It’s better than a risk of total loss, but it’s still a risk.
Let’s turn to how to do this in practice.
1 How Price Compression Happens
The way that these 2x coins are constructed is through shorting a stable coin, in this case USDC, and buying a proportionate amount of the primary coin, ETH in our case.
How AOTB Leverages Crypto Trades
So, if Pulse, the company that makes these coins had $10,000 and they wanted to create their ETH 2x product from that, they would short $7500 USDC (= borrow it from other people and sell it on the market).
They would then have $7500 + their initial $10,000. At that point, they’d buy $17,500 of ETH. That gives them 1.75x leverage.
Now, the price of ETH can surge a lot over a 24 hour period, and since that’s their basic period for readjusting their balance (they call it an epoch), they might end up with better than $23,000 of ETH.
At that point, they’d sell that ETH and pay back some of their borrowed USDC (from shorting) to bring their leverage ratio down to below 2.3x
That’s why the ETH 2x coin can range between 1.75x and 2.3x.
Now, price compression results from that average daily rebalancing stuff that’s part of how the coin is constructed. Consider the following question, and we’ll assume a 2x constant leverage ratio to make the math easier.
- Day 1 ETH goes up 5%
- Day 2 ETH goes down 5%
What’s the difference between the ETH value and the ETH 2x value?
Well, if you started with $10,000 in ETH, then after Day 1 you’d have $10,500. On Day 2, the 5% loss = $525, so you’d have $9975 for a slight loss of $25 dollars.
For the 2x coin, after 1 day, you’d have $11,000. But the Day 2 loss would be $1100, so you’d be at $9,900. This means you’d incur a $100 loss = 4x the loss of the un-leveraged fund.
That difference in performance between the leveraged and unleveraged asset is called, in the jargon of the finance world, “beta drift.”
If these sorts of declines were to go on for several days in a row, as happened in May of 2021, then the 2x fund would lose massively relative to the underlying fund. That is how price compression happens.
It’s also why these leveraged coins are quite risky and I’ve been reticent to talk much about them even with my coaching clients. I did come to a sort of solution for this problem, though.
2 An Outline For A Solution
To be clear, there is no general solution for this problem. The amount of beta drift for a leveraged asset is what mathematicians call a “path dependent” function.
That just means that you can’t write a function in advance to predict how it will go. There is no pure mathematical answer, in short.
But that doesn’t mean that you can’t have an empirical answer–one based on statistics or the like.
Now, in order to make this work, your strategy can’t use the typical momentum indicators that I’ve written about in other lessons. For example, Lesson 2 of The Art of The Bubble discusses how to improve over using the 200 day simple moving average to get better returns.
That works just fine with un-leveraged securities, but a moving average, by definition looks backwards over the past 200 days (for example) to smooth out a trend line.
If you speed up that timeframe to even just 12 days, you’re still looking backwards. Also, because you’ve reduced the window of observation to 12 days, you have an unreliable sample for a real trend.
Leverage Crypto Trades for Good
The better answer is to use futures market data. This is data that comes from people making bets on the direction of coins over the next month (usually). The ratio of positive bets to negative bets can be used as a way to crowd source the direction of the market and that’s at least a forward looking view on the market.
Now, BTC and ETH are the only coins with much futures market data, but since it worked on stocks, I figured it would work on cryptos. I applied the same techniques and, yes, so far it has worked out well.
Obviously, the technical details of this process are complex and I couldn’t finish them in many hours of discussion. They also require a certain amount of mathematical sophistication.
For my subscribers, you’ll simply see when I buy and sell ETH 2x and can follow if you wish. Coaching clients, we’ll talk about whether you want to include this strategy in your portfolio.
But I want to make these free standing lessons. What is anyone else to do?
3 What to Try Instead – By Way of Conclusion
At this point, I’ve made clear how these 2x coins work and why they’re really pretty dangerous. Since cryptos are like a leveraged bet on the stock market anyway, maybe it’s enough just to ride bubbles up.
But if you want more exposure, then for reasons that I explained in Lesson #8 of The Absolute Beginner’s Guide to bubble trading, it’s probably best to wait for a big dip in the crypto-market before buying into a leveraged coin. Then, it might make sense to put a small portion of your portfolio into these 2x coins.
If the market bounces back, you will be very handsomely rewarded. If not, because you’ll sell shortly after, you’ll limit your downside to probably 20% – 30%.
I think that in this way, most people can take advantage of 2x coin returns without risking total or near total losses. You’ll also increase your ability to participate in the upside returns of established coins like Bitcoin and ETH also.
This week I wrote a number of pieces that are related to this post, so you might want to have a look if you’ve missed them.
That’s it for this week. Remember to join us on Discord if you haven’t already.
General financial disclaimer: This post is provided for entertainment purposes only. I am not giving you financial advice and I am not a financial advisor. You should expect no financial returns one way or another based on my statements. These points hold equally for any statements that could be attributed to The Art of The Bubble or any related business entities. If you decide to buy or invest in anything, then your returns and potential losses are your own. No statements about taxation are taxable advice and you are encouraged to consult your own tax professional. You are also encouraged to do your own due diligence before investing in anything.