Is There A Hidden Danger to Staking Volatile Tokens?

Exploring the risk and reward dynamics of Web3 staking, this article delves into strategies for balancing volatility and diversifying investments for optimal returns.

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When it comes to trading, we as humans have a hunter mindset. We are always looking for the best deal, looking for those extra rewards, and looking for that slight edge. It makes us feel great when our hard work pays off, and it is devastating when we end up further behind than when we started. For Web3 trading, there are many different ways we can approach finding a good strategy. Buying and holding is the most basic strategy, but depends completely on the future price of the token. Day trading can generate major gains, but can just as easily destroy your balance and has the added risk of eroding profits through all the gas fees paid with each transaction. Various platforms can offer added rewards and benefits to their user communities, with results varying widely. However, one of the tried and true programs we see in Web3 is that of staking.

Staking is an interesting symbiotic relationship. Platforms can’t succeed unless they build up stable liquidity, and so they incentivize users to buy and hold tokens through staking programs. These too can vary widely based on the length of staking, the rewards given as the tokens are staked, and many other attributes that can be thrown in by the platform. At the end of the day, though, the premise is simple: buy platform tokens, keep them for a certain amount of time to give the platform liquidity, and as the platform succeeds you will earn rewards depending on how much and how long you stake.

This is a great arrangement and has resulted in many platforms building up enough liquidity to really build a user base and start growing into large, stable ecosystems. Users, for their part, have been able to earn strong returns in ways that traditional investing can’t offer, and without having to resort to high risk ventures like constant day trading (which has an eye-watering failure rate).

There is just one problem though. When staking on a platform with an especially volatile token, the risk/reward calculation becomes exaggerated. Staking nearly always provides rewards in the token that is being staked, so there is a complete lack of diversification. The more volatile the token is, the more the risk/reward equation changes, so after a month or year of staking, you could be rolling in riches or wondering why you would make such a stupid decision and lose all your money. Let’s look at these extremes to get a better idea of the real risk profile of staking, especially when the token has a lot of movement on the market. We will also look for different ways to diversify this risk, such as using the rare program that gives rewards in stablecoin (dYdX Chain, for example).

Best Case

Let’s have fun first with the best case scenario. In this case, a token is swinging wildly but seems to be on an overall upward trajectory. Somehow you manage to grab some tokens as its price is in a dip, and stake them on a strong program that offers solid returns. If you can ignore the major price dips going forward and keep the tokens staked, the results in this case will be positive. As long as the token continues to climb in price, at the end of staking you could conceivably sell for a profit, but also have a decent amount of rewarded tokens, which can also result in a strong profit as their value has increased. Though you had to weather a storm of volatility, you came out ahead.

Worst Case

Now let’s take all those warm feelings and crush them. In the opposite case, you see that a token is volatile but rising, and you rush to buy some, staking it into what looks like a strong program. So far, this scenario is exactly like the best case version. However, volatility (by definition) goes both ways, and if you hang onto the token to maintain the staking rewards, but the token value continues to slip in a downward direction, you will see that total wealth continues to drop. At the end of the staking period, you’ve earned rewards, true, but they are in the form of a token that is worth considerably less than it was before. Not only have you realized a loss on your initial purchase of the tokens, but your calculated gains (in real value, not in the number of this token) are less as well. It’s true that the rewarded tokens you have staked still count as a profit. However, there is a nasty reality called opportunity cost that must be factored into the profit calculations. If you could have invested safely and earned a modest profit, you have to compare that profit with what total loss you’ve encountered (the loss of the initial investment, offset by any rewarded tokens you’ve earned). This makes the loss feel even worse, but it is the correct way to calculate the situation.

Balancing the Risk

So how do we find a way to diversify or benefit ourselves more? There are a number of options, each with pros and cons. The most obvious answer would be to not stake everything on one platform, but rather spread out investments to better the chances of your investment matching the overall market. It’s important to expand beyond the market too, but how much will depend on the individual. As mentioned before, finding a rare program that can help diversify is great too. dYdX is one of very few that rewards staking in stablecoin, giving an automatic diversification, with the additional benefit that doing so signals a great deal of confidence in the overall growth of the platform.

No matter what, each person needs to have a heart to heart with themselves and understand how extreme or modest their own risk appetite is. The old saying is still true: “Never risk more than you are willing to lose”, and this holds strong with even the safest looking investments. However, those who seem to benefit most work on sacrificing the most extreme wins with a diversified approach, increasing the odds of ending up ahead over time.