Leveraged tokens and perpetual futures represent two distinct approaches to achieving leveraged exposure. At the heart of leveraged tokens' unique behavior lies their rebalancing mechanism, designed to maintain leverage within a targeted range. This contrasts with perpetual futures, where the leverage factor fluctuates in tandem with the price movements of the underlying asset.

But beyond the mechanics, how do these instruments fare in the real world? Which scenarios favor the performance of one over the other? And importantly, how can one use this knowledge to select the most appropriate instrument for their needs?

This article delves into these questions by examining various historical price scenarios and directly comparing the outcomes. The goal is to illuminate the nuances of each option, helping users to make informed decisions in the evolving landscape of leveraged DeFi products.

Scenario one: Trending markets

Trending markets, characterized by clear and consistent upward or downward price movements, provide an excellent example of the distinct behavior between leveraged tokens and perpetual futures. Recent instances of such trends include the Solana rally, where its value surged from $20 to $200, and the Bitcoin rally, with its price increasing from $27,000 to $73,000, both of which unfolded between October 2023 and March 2024.

In Figure 1, the performance comparison between the leveraged token (pink line) and the perpetual future (grey line) demonstrates a clear advantage for the leveraged token. The underlying mechanism responsible for this outperformance is the rebalancing process, marked by blue vertical lines. Rebalancing automatically adjusts the position's notional value - essentially the total size of the leveraged exposure - whenever the leverage factor hits a specific threshold. This adjustment leads to increased exposure, which in turn amplifies returns as the price continues to rise.

In this particular example, the perpetual future’s leverage factor had decreased from 2x to 1.06x with a notional of $18,399 by March 18th. The leveraged token’s leverage factor, on the other hand, remained around 2.02x with a notional of $96,144, showcasing the potential benefits of leveraged tokens under these market conditions.

Scenario two: Price movements that trigger liquidations

In contrast to the behavior of leveraged tokens in scenario one, their performance during adverse price movements reveals a different advantage. In such scenarios, the rebalancing mechanism decreases the notional value, leading to reduced leveraged exposure. This significantly mitigates the risk of liquidation by decreasing exposure during downturns.

Perpetual futures, however, do not share this rebalancing feature. They exhibit a fluctuating leverage factor until the market reaches a liquidation price.

Figure 2 illustrates such a scenario. The decrease of the $LINK price during the first week of January 2024 led to the liquidation of the perpetual future shortly after the position was opened.

In contrast, the leveraged token, although experiencing a margin decrease similar to that of the perpetual future, underwent multiple rebalancings throughout the downturn. These rebalancing actions effectively reduced the amount of borrowed funds, thereby decreasing leveraged exposure and preventing liquidation. This mechanism allowed the leveraged token to maintain its position throughout the period of declining prices, showcasing the risk management capabilities inherent in the structure of leveraged tokens.

Scenario three: Flat and volatile price movements

The first two scenarios provided insights into market conditions where leveraged tokens tend to outperform perpetual futures. However, rebalancing also introduces a potential downside in certain market environments. Specifically, in markets characterized by flat or volatile price movements, where the need for frequent rebalancing - both uplevering and downlevering - can result in what is known as volatility decay. The mathematical foundation underlying this process is explained in the official TLX documentation under the section “Volatility decay”.

Perpetual futures do not face this issue and usually outperform leveraged tokens under these market conditions, given they don’t get liquidated.

Figure 3 depicts a scenario of continuous sideways movement and high volatility in the $LINK price. It clearly demonstrates the depreciating margin of the leveraged token over time, leading to underperformance compared to the perpetual futures contract. The impact of volatility decay on the leveraged token would be further intensified by higher leverage factors, highlighting the challenges leveraged tokens face in volatile, directionless markets.

Scenario four: Continuous adverse price development

In scenarios with continuous adverse price movement, rebalancing can mitigate but not prevent the impact on the margin. Should the price of an underlying asset persistently move against a position, the margin of a leveraged token will inevitably decay over time. This highlights the limitation of rebalancing in safeguarding a position against prolonged unfavorable market trends.

Figure 4 showcases the dynamics of a short position during the price appreciation of $ETH from February to mid-March 2024. The perpetual future faced liquidation at the beginning of March. In contrast, by March 15th, the leveraged token had still preserved 30% of its margin. However, should this upward trend continue, the margin of the leveraged token would decay almost entirely, illustrating the gradual impact of adverse price movements on leveraged token positions.

Conclusion

Leveraged tokens and perpetual futures each shine under different market conditions. Leveraged tokens outperform in trending markets thanks to their rebalancing mechanism and offer protection against liquidation in adverse movements. However, this same feature leads to volatility decay in flat or volatile markets, where perpetual futures tend to excel, assuming they avoid liquidation. While leveraged tokens can mitigate losses in downturns, prolonged adverse trends can still erode their margin. Users must consider these dynamics, balancing the potential for amplified returns against the risks of volatility decay and market movements, to choose the right instrument for their strategy.

Disclaimer

This article is for informational purposes only and is not intended as financial or investment advice. All content reflects the author's views and should not be seen as specific investment recommendations. Investors should do their own due diligence or consult a professional advisor before making investment decisions. The author bears no responsibility for any financial losses resulting from investment choices based on this article.

The model used for generating the charts excludes funding rates and fees for both leveraged tokens and perpetual futures. This exclusion shouldn't notably affect the performance comparison.