The ProShares Bitcoin Strategy ETF (BITO) uses Bitcoin futures to gain exposure to Bitcoin price movement. Although this has not been a viable way to track Bitcoin, recent market observations show that it will be a good way to do so in the future. Furthermore, the growing prevalence of cryptocurrencies suggests that this market and its derivative markets will only grow stronger over time, further securing BITO’s ability to track Bitcoin. As such, BITO is a catch for anyone who wants exposure to Bitcoin through a centralized, liquid entity.
BITO has not performed well in the past due to Contango in Bitcoin Futures
BITO’s holdings and prospectus show that it uses short-term CME Bitcoin futures, rather than actual Bitcoin, to gain exposure to the Bitcoin price. Since CME Group is a well-respected derivatives exchange and its products are aligned with SEC regulations, a Bitcoin ETF based on CME futures has been deemed acceptable by the SEC. Bitcoin ETFs based on actual Bitcoin have curiously faced greater pushback from regulators.
In the past, Bitcoin futures have exhibited a steep contango, where the futures traded above the spot price. Whenever BITO had to sell expiring contracts to buy the next month’s contracts, it had to do so at a price higher than the spot price. This is called negative roll performance. Over time, a negative roll yield erodes the capital of the fund and produces a huge tracking error between the spot price and the net asset value of the fund. Examples of this are VIX funds that seek to track short-term movements in the VIX by buying VIX futures contracts. Funds can never follow the VIX for long because VIX futures are almost always in contango, causing these funds to experience negative returns and erode capital each month.
For a while, Bitcoin futures exhibited an equally destructive contango. This explains BITO’s underperformance against Bitcoin since the former’s inception in October 2021. In less than six months, just five instances of contract rollover, BITO has already underperformed by more than 2%.
(Source: Alpha Charts Research)
Common reasons for contango and offset
Contango makes sense in the context of commodities. For example, oil futures contracts are usually in contango. When someone sells a futures contract, they are promising delivery of that item at a later date. Higher future prices reflect their cost of holding physical oil, called the cost of carry. In most commodities, the cost of carry exists because it is impractical and expensive to have to store physical commodities in large quantities.
Futures contracts sometimes feature backwardation, where prices fall as the time to expiration increases. This usually happens when the physical commodity experiences a surge in demand, pushing the spot price above future prices. Conversely, supply can be expected to increase in the future, despite a current shortage. Naturally, this would result in a high spot price due to the shortage and a lower expected future price due to an expected increase in supply. Another way of looking at backtracking is that the holder of the physical asset incurs a cost that benefits him. For example, if the futures contract was for a stock that pays a dividend, then naturally the future price of the stock would be lower because the shareholder would have received a dividend before having to deliver the stock.
Basic Bitcoin Trading Is Fading
A basis trade takes advantage of the spread between spot prices and future prices. Assuming a commodity is in contango, one can buy the physical asset at the spot price and sell futures contracts (which are at a higher price) to guarantee a risk-free profit. The reason this doesn’t work, and the contango persists, is that to store the physical asset the trader would have to pay the cost of carry, which effectively eliminates the risk-free profit.
Now consider Bitcoin. It costs nothing to store because Bitcoins are just numbers on a distributed ledger. The registry is immutable. Coins are secure as long as the private key of the owner’s address is not known to others. To liquidate Bitcoins, the owner can go to an exchange, use their private key to send the Bitcoin to a destination address, and receive USD. To buy Bitcoin, a trader simply does the reverse. It is a simple and inexpensive process. Bitcoin also does not generate cash flow or yield.
To summarize, the important difference between Bitcoin and other commodities is that Bitcoin should not have a cost of carry. It pays no dividends and it costs nothing to store securely. There is a liquid market for it and it is easily transferable between people. Source of contango or offset for commodities is not present in Bitcoin.
As such, basic Bitcoin trading is very viable. Traders can easily get a risk-free profit by going long in the spot market and selling it in the futures market. And it happened. The opportunity for this basic trade has diminished and the futures curve is beginning to look like a straight line, albeit sloping slightly upwards.
This can be seen in a time series of the spread between Bitcoin and BITO. When BITO started trading, it consistently underperformed Bitcoin. Indeed, Bitcoin futures were in strong contango. Since late January, we’ve seen many more instances of Bitcoin underperforming BITO, so on average neither is consistently doing better than the other. This is when basic Bitcoin futures trading started to fade.
(Source: Yahoo! Finance for historical prices, author’s calculations via Excel)
Due to the nature of Bitcoin, I expect future prices to generally be in line with the spot price. Whenever there is a large gap, arbitrageurs step in to make a risk-free trading profit. Ultimately, future price premiums should only represent the risk-free rate plus transaction costs and a risk premium taking into account the possibility of having one’s coins stolen (which would be close to zero if the private keys are secure ).
If Bitcoin futures continue to stay in line with Bitcoin spot price, BITO will track Bitcoin price very well. The growing prevalence of cryptocurrencies means that more and more eyes will be on this space in search of opportunities. This will naturally make the market more efficient. Because we have established that there is little cause for contango or offset for Bitcoin, the only source of tracking error would be monthly rollover transaction fees. Eventually, BITO managers may choose to buy longer dated futures contracts to minimize this cost.
This makes BITO a good vehicle to track Bitcoin in the future. Additionally, BITO’s Liquid Options Channel gives holders the ability to trade weekly options. Investors can sell covered calls against their BITO holdings, taking advantage of its high implied volatilities to earn income. They can also sell cash secured put options to collect revenue. Alternatively, shorting BITO or buying BITO put options will be a good way to bet against Bitcoin. Although Bitcoin derivatives exist on other exchanges, these alternatives are generally unregulated, which may not match the risk tolerance of many investors.
BITO is a holdback for anyone who wants exposure to Bitcoin without having to open a separate account on a cryptocurrency exchange. The fact that it has an extremely liquid options chain makes it better than real Bitcoin if one is looking to trade Bitcoin related options in a regulated environment.