Leveraged tokens remove some of the risks that traders face when taking on leverage to increase their price exposure. For example Float's leveraged tokens do not expose users to risk of liquidation, or the complexities of managing collateralised debt positions.
However, holding leveraged tokens can expose you to a phenomenon called ‘volatility decay’.
Volatility decay can be defined as the difference between your expected portfolio performance when holding a leveraged asset, and your actual portfolio performance.
That’s because leveraged assets don’t behave the way most traders expect them to.
If you’re holding a 1x leveraged asset in optimal market conditions and the price goes up 10% over a week, you would correctly expect a 10% increase in your portfolio.
If you’re holding a 2x leveraged asset over the same period, you may expect it to increase by 20%, but that isn’t the case.
This is because the leverage of k only increases the magnitude of a single price update by a multiple of k, and not the cumulative return figure by a multiple of k.
Since there will be many price updates in the week between opening your position and checking your portfolio in the above example, volatility decay will cause the actual movement of your portfolio to be radically different to the expected value.
This difference could be positive or negative meaning, you could end up with more or less than expected.
Volatility decay depends on multiple factors whose effect can be ambiguous, including the leverage of the position, the volatility of the underlying asset, the frequency at which the price is updated, and the duration the position is open for.
Because of this we advise users to take care when holding a leveraged asset over a long period.
Even 1x leveraged short positions can be subject to volatility decay, although to a lesser extent than higher leveraged assets.
To learn more about volatility decay, watch our seminar on it here.