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Leveraged Tokens Guide

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Leveraged Tokens Guide

Last updated: Tuesday, 1 February 2022

Leverage tokens offer a leveraged position in trading, letting you increase your earnings (and losses!)  - without any of the hassle of maintaining a position like in margin trading. We’ve got everything you need to know about leveraged tokens, including how leveraged tokens work, the benefits and risks and what leveraged tokens mean for your tax bill. 

What are leveraged tokens?

Put simply, a leveraged token gives you a leveraged position when trading. A leveraged position multiplies your earnings… and your losses. They’re essentially a tokenized version of a more traditional leveraged contract.

For example, ETHBULL is a 3x long ETH leveraged token. So it triples the profits of ETH gains, as well as tripling the losses. So if the price of ETH increased by 1%, ETHBULL increases by 3%. Similarly, if the price of ETH dropped by 1%, the price of ETHBULL drops by 3%.

As you can see from the example above, leveraged tokens are high risk and you shouldn’t invest in them without fully understanding the potential losses. So let’s look at how they work. 

What are leveraged tokens?

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How do leveraged tokens work?

You can get long (bull) or short (bear) leveraged tokens. Long leveraged tokens bet for the price of the underlying asset to go up, while short leveraged tokens bet for the price of the underlying asset to go down.

There’s also fixed leverage tokens and variable leverage tokens. Fixed leverage tokens have a fixed position. Fixed leverage tokens have a fixed position. As in, the amount of leverage you have won’t change - it’ll always be 0.5X, 1X, 2X, 3X and so on. So you’ll only ever gain or lose a certain amount.

Meanwhile, variable leverage tokens don’t maintain a constant leverage. Instead they aim for a target range of variable leverage - between 0.25X and 4X normally. This means you can gain much more and lose much more.

To maintain the target leverage with the underlying asset, leverage tokens go through what’s known as rebalancing and it happens automatically. Rebalancing works slightly differently on every crypto exchange offering leveraged tokens, so we’ll give a general overview.

Normally rebalancing happens at a set point in the day - like 2AM. However, if it’s been a volatile market and the price has dropped or risen by more than 10%, many leveraged tokens automatically rebalance at this point. Each platform will have a different rebalancing protocol.

When a leveraged token rebalances, if the price has gone up, the profits are reinvested into the underlying asset. If the price has gone down, you’ll sell some of your position to cover the losses. 

Where can I buy and sell leveraged tokens?

There are a few large crypto exchanges offering leveraged tokens including:

You can buy and sell leveraged tokens on the spot market, like you would any other token or coin. Depending on the platform, you can also redeem them for the value they represent.

There are also an increasing number of decentralized exchanges offering leveraged tokens.

What are the benefits of leveraged tokens?

The obvious benefit of leveraged tokens is that if you manage to bet which way the market will go, you’ll have higher gains than you would when you trade a non-leveraged coin.

As well as this, leveraged tokens have some key benefits over other leveraged products. For starters, unlike with margin trading - you don’t need to maintain a margin. So you don’t need to have a given amount of collateral to open a position, you can just buy the leveraged token and you automatically have that position.

This is because risk is automatically managed with leveraged tokens. You don’t need to add more collateral if the price goes down or close if the price goes up thanks to the rebalancing function. This means the risk of liquidation is much lower with leveraged tokens.

Because of the lowered risk - most exchanges charge a lower management fee to keep your position open than for traditional leveraged products.

They also increase your liquidity. You might only have a certain amount you can currently invest. So you can increase your profits without investing more by leveraging your position with lower risk than many other leveraged products. 

Leveraged tokens pros

What are the risks of leveraged tokens?

The obvious risk is loss. If you bet the wrong way, you’re going to lose a lot - much more than you would have done if you hadn’t taken a leveraged position. Particularly for variable leveraged tokens where you have no fixed position, the losses can be huge.

While the risk of liquidation is much lower thanks to rebalancing - it doesn’t mean that it couldn’t happen if the market conditions were rough enough.

One of the biggest risks around leveraged tokens is what’s known as volatility decay. This is the negative impact of a volatile market on an investment. For example, let’s say you bought $100 of ETH and the price increased by 20% in a day, giving you $120. The day after, it decreases by 20%, so you lose $24. You’re left with $96. Easy enough, but now imagine you bought a leveraged position instead.

You buy $100 of ETHBULL - a 3X long leveraged token. The first day your price goes up by 20% to $160. The next day it drops by 20% - losing you $96 and leaving you with $64. You’ve lost more of your assets than you would have normally because of your leveraged position. This is an extreme example, but it shows that even minor losses would eat away at the value of your asset much faster than with regular crypto trading.

There’s also additional fees involved in leveraged tokens compared to regular cryptocurrencies. They have a management fee (normally of between 0.01% - 0.03%), as well as a redemption fee if you choose to claim the value of the underlying asset instead of selling your leveraged token.

Leveraged token risks

Leveraged Tokens Tax

Got big gains from your leveraged tokens? The taxman wants to know about them.

Like any other cryptocurrency, leveraged tokens are taxed. But to complicate matters, no tax office has yet issued any guidance on how leveraged tokens are taxed. So we need to take the current crypto tax rules and apply them to the different types of transactions you can make related to leveraged tokens.

On the face of it, there’s a few transactions that could possibly happen involving leveraged tokens:

  • Buying a leveraged token.
  • Selling a leveraged token.
  • Redeeming a leveraged token.
  • Rebalancing a leveraged token.

Let’s take a look at each.

Do you pay tax when buying a leveraged token?

Depends on what you buy it with.

If you buy a leveraged token with fiat currency - like USD, this is tax free. Buying crypto with fiat currency is not subject to tax.

However, if you buy a leveraged token with another cryptocurrency - like BTC or ETH - this would be subject to Capital Gains Tax. This is because crypto to crypto trades are seen as a taxable event.

So for example, let’s say you bought ETHBEAR using ETH. You’d need to pay Capital Gains Tax on your ETH. This would be on any increase in value (capital gain) between when you acquired your ETH and when you sold it. If it hasn’t increased in value, you would have a capital loss instead and wouldn’t pay Capital Gains Tax on it. 

Do you pay tax when selling a leveraged token?

Yes. Regardless of whether you sell your leveraged token for crypto or fiat currency - you’ll pay Capital Gains Tax on any profit.

So you’ll pay tax on the difference between when you bought your leveraged token and when you sold it. If the value has increased, you’ll pay Capital Gains Tax on that profit. If the value has decreased, you’ll pay no Capital Gains Tax. But you can use that capital loss to offset your gains and reduce your tax bill - see more here

Do you pay tax when redeeming a leveraged token?

It doesn’t matter that it’s a totally different transaction - redeeming your leveraged token is seen as a sale from a tax perspective. You’re trading one token for another.

This means you’ll pay Capital Gains Tax on the difference in value from when you bought your token to when you redeemed (sold) it. If the price has increased, you’ll pay Capital Gains Tax on the difference. 

Leveraged tokens rebalancing tax

Tax offices - including the IRS - have given no clear guidance on rebalancing yet. However, we can think of rebalancing as two separate transactions. If the price goes up, you’re buying more crypto by reinvesting - so look at the buying section above. If the price goes down, you’re selling some of your asset - so look at the selling section above.

Leveraged tokens tax

How Koinly crypto tax calculator can help

Koinly calculates all your crypto taxes for you - saving you hours of maths and spreadsheets. We work with all major crypto exchanges and wallets - including platforms offering leveraged tokens like Binance, FTX and more.

All you need to do is sync the wallets and exchanges you use with Koinly using API or by importing a CSV file of your transactions. Once you’ve done this, Koinly will identify your taxable transactions, cost basis, capital gains, capital losses, income and more. You can see all this in your tax summary - totally free of charge.

Tax summary Koinly

Once you upgrade to a paid plan - you can download a tax report based on your location, ready to handover to your tax office. For example, the IRS Form 8949 and Schedule D for US investors, the ATO myTax report for Australian investors or a HMRC Capital Gains Summary for UK investors.

Get your crypto tax report today!

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