What is compounding?

What is compounding? How does it affect BTCSHORT? The following article is an in-depth explanation into how compounding affects BTCSHORT.

Introduction

In previous educational posts, we’ve talked about Amun’s inverse token, BTCSHORT, and how it tracks -1x of Bitcoin’s daily performance. If Bitcoin’s returns -5% in a single day then BTCSHORT aims to return 5% in the same day. As such, BTCSHORT aims to maintain a-1x notional exposure to the daily percentage change in the value of Bitcoin. The token is designed to follow its objective over a daily period before resetting. In this post, we exclude all fees and expenses associated with BTCSHORT and investing in Bitcoin.

For example, let’s say that both BTCSHORT and BTC are priced at $100 on day one. If over the day, Bitcoin’s price falls to $90, this is a -10% return. On the other hand, as BTCSHORT follows a -1x exposure to Bitcoin’s daily returns, this means that the value of BTCSHORT increases by 10% and therefore moves to $110. At 5 PM Central European Time (CET) on the day, BTCSHORT resets which means that both Bitcoin and BTCSHORT have a new starting point for the next 24 hours. So any move by Bitcoin after this point until 5 PM the next day (daily) will be replicated -1x in BTCSHORT’s 1-day returns on the following day until 5 PM. Therefore, Bitcoin’s price action (ie, daily return) starting from 5 PM CET in a given day to 5 PM the following day will be multiplied by -1 to set the new value for BTCSHORT.

Compounding

Compounding simply means that gains or losses made on one day are added to the start price of the next day and used when calculating the next day’s returns. You may recognize compounding from interest on bank accounts.

In the diagram below we compare simple interest and compounding interest to explain how compounding works. In both cases, we start with an amount of $1,000 and the interest is 10% of that – $100. In the simple case, this means that on each day exactly $100 accrues as interest. Therefore the total amount of interest after three days is $300 - with a total amount of $1,300.

This is different for compounding interest. Here the interest made in day one is added to the base amount in day two. This means $100 is added to the base amount of $1000 so the base amount of day two is $1100. Therefore on day two, the total interest is 10% of the new base amount and therefore 10% of $1100 which is $110. This repeats again on day three. In the end, this means that the interest gets larger as the base amount gets larger. In total, compounding leads to a total interest of $331 in this example. Compounding means that total returns over a week, for example, depending on the daily returns within the week and changes to the initial base amount due to the daily returns on each day within the week.

Due to the daily reset of the BTCSHORT token, compounding comes into effect after a token is held for longer than a day (past 5 PM CET).This is extremely risky and the reason why the advised holding horizon for BTCSHORT is equal to or less than a day, but not more.

For BTCSHORT, even though it tracks a -1x exposure with Bitcoin on a daily basis, the daily reset causes compounding. This can lead to positive or negative effects if BTCSHORT is held for more than one day as BTCSHORT’s price can be volatile over multiple days. If BTCSHORT is held for longer than its reset period of a day, then the effects of compounding on its return profile may be unintuitive.

As such, it is important to note that holding BTCSHORT for longer than a day can mean that compounding works against you, causing unexpected losses.

Compounding can work against you — high volatility

Unlike in the simple vs. compounding interest example, compounding can work against your holding in BTCSHORT if held for longer than a day. In a volatile market the gains and losses that BTCSHORT makes will generally see it underperform compared to the returns of Bitcoin multiplied by -1x. If the token’s value rises on day one and then is followed by a loss of the same percentage amount on day two, the loss is applied to a larger amount than the gain. This means the token will lose more than it gained even if the price of Bitcoin ends up being the same after two days. In a similar fashion, if the token’s value falls on the first day then rises by the same percentage amount on day two. The token’s rise is applied to a smaller amount than the fall. This means that the token will again lose more than it gained even if the price of Bitcoin ends up being the same after two days.

Compounding can work for you — low volatility

Compounding can also work in your benefit if Bitcoin’s price change over a few days is not very volatile and follows a trend. For example, if Bitcoin’s price is stable but trending in a negative direction then BTCSHORT will benefit. This is because the daily returns on both days are both in BTCSHORT’s favour and gains made on day two benefit from the gains made on day one as the base amount, which the returns are applied to, increase.

Conclusion

The correct holding period for BTCSHORT is that of of a time period of one day or less. Due to compounding, investing in BTCSHORT over longer periods of time can be increasingly risky and lead to unexpected and inadequate results. Visit our website to learn more about BTCSHORT.

Disclaimer

This document has been prepared and issued by Amun Limited (“Amun”). This document may contain market commentary. All information used in the publication of this document has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this document or the information contained/referenced herein.

This document may contain independent market commentary prepared by Amun based on publicly available information. Although Amun endeavors to ensure the accuracy of the content in this document, Amun does not warrant or guarantee its accuracy or correctness. Any third party data providers used to source the information in this document make no warranties or representation of any kind relating to such data. Where Amun has expressed its own opinions related to product or market activity, these views may change. Neither Amun, nor any affiliate, nor any of their respective officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this document or its contents.

Crypto asset trading involves a high degree of risk. The crypto asset market is new to many and unproven and may have the potential to not grow as expected. Currently, there is relatively small use of crypto assets in the retail and commercial marketplace in comparison to relatively large use by speculators, thus contributing to price volatility that could adversely affect an investment in crypto assets. In order to participate in the trading of crypto assets, you should be capable of evaluating the merits and risks of the investment and be able to bear the economic risk of losing your entire investment.

Nothing in this document (or any other documents mentioned herein) is or should be considered to be an invitation to enter into an investment and is not intended to be an offering of securities in any jurisdiction nor does it constitute an offer or an invitation to sell shares, securities or rights belonging to the Issuer or any related or associated company. This document has not been registered with or approved by any regulator in any jurisdiction. Readers are cautioned that any historical performance information or forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results or performance may differ materially from those in the forward-looking statements as a result of various factors. The information contained herein may not be considered as economic, legal, tax, or other advice and users are cautioned against basing undue reliance, investment decisions or other decisions solely on the content hereof.

Any historical performance included in this document may be based on back testing which is a means of evaluating a particular strategy by applying it to historical data to simulate what the performance of such strategy would have been. Back tested performance is purely hypothetical and is provided in this document solely for informational purposes and neither represents actual performance nor should it be interpreted as an indication of actual or future performance.

The Tokens are complex products which incorporate a high degree of risk and should only be bought or traded in by persons with appropriate technical knowledge who have experience with similar products.

The Tokens have not been registered with or approved by any regulator in any jurisdiction. The Tokens are not available for purchase by individuals or entities who are ordinarily resident in the United States, Switzerland, the Seychelles or any other country on the Prohibited List.

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