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 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.
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.