Volatility Decay: The Impact of Compounding in Leveraged Products
Volatility decay is the loss of returns in leveraged tokens and leveraged ETF products caused by daily rebalancing and compounding. It is generally more pronounced when prices fluctuate repeatedly, leverage is higher, or the holding period is longer.
Basic Concepts
Leveraged products track a multiple of the underlying asset's daily return, rather than a multiple of its long-term cumulative return. Because leverage resets daily, when prices rise and fall alternately, the compounded result may be lower than the figure obtained by directly multiplying the underlying asset's total return by the leverage multiple; even if the underlying ultimately returns to around its starting point, the product may still incur a loss.
How Compounding Causes Losses
An increase and decrease of the same percentage do not cancel each other out: first up 10% then down 10%, resulting in a loss of 1%. If the product offers 2 times daily leverage, the corresponding movements are first up 20% then down 20%, resulting in a compounded loss of 4%；3 times the product under the same sequence loses approximately 9%, showing that leverage amplifies the drag caused by volatility.
Impact of Market Direction
The degree of decay is mainly affected by the underlying asset's price fluctuation, the leverage multiple, and the holding period: the greater the volatility, the higher the multiple, and the longer the holding period, the stronger the cumulative impact of daily rebalancing is generally likely to be. However, when prices move consistently in the same direction, daily compounding may also cause cumulative returns to exceed the nominal leverage multiple.
Risks in Crypto Markets
Crypto assets are generally highly volatile, and leveraged tokens may accumulate losses quickly during periods of fluctuation. Therefore, these products are generally used for short-term strategies rather than long-term holding. During a sideways market lasting several days or weeks, the value of a leveraged token may still be significantly eroded even if the underlying asset does not decline substantially.
Original Tutorial
https://www.binance.com/en/academy/glossary/volatility-decay
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