What is a Bitcoin futures ETF?

Bitcoin futures contracts, explained

A financial agreement to purchase or sell an item, such as wheat, oil or Bitcoin, at a predetermined price on a given future date is known as a futures contract.

These contracts are used for both risk management (hedging) and speculation on price movements. Let’s understand what this means with an example:

Imagine a miner (seller) expects to mine 10 Bitcoin (BTC) in three months. Worried about a potential price drop, the miner enters a futures contract to sell 10 BTC at $90,000 per BTC three months from now. This locks in $900,000 in revenue, regardless of the Bitcoin’s market price in three months. This is a common hedging strategy.

A trader (buyer), believing Bitcoin’s price will rise even higher, agrees to buy 10 BTC in three months at $90,000 per BTC.

Scenario 1: Bitcoin’s price rises above $90,000

If Bitcoin’s price rises to, say, $95,000 in three months, the buyer (trader) who bought the futures contract at $90,000 has a potential profit. Here’s how they can realize it:

• Physical settlement (less common): They could take delivery of the 10 BTC at $90,000 and immediately sell it on the open market for $95,000, making a $50,000 profit (10 BTC x $5,000 profit/BTC).
• Cash settlement (more common): Futures contracts are often cash-settled. In this case, the buyer wouldn’t receive actual Bitcoin; instead, they would receive a cash payment equal to the profit they made based on the difference between the contract price ($90,000) and the market price ($95,000) at the contract’s expiration.
• Closing out the position (most common): Before the contract expires, the buyer can sell another futures contract with the same expiration date to offset their original purchase. This “closes out” their position. If the market price is $95,000, the buyer can sell the offsetting contract at approximately that price, realizing the $5,000 profit per BTC ($50,000 total).

Scenario 2: Bitcoin’s price drops below $90,000

If Bitcoin’s price drops to, say, $85,000 in three months:

• The seller (miner) is still obligated to sell their 10 BTC for $90,000, securing a better price than the market.
• The buyer who agreed to buy at $90,000 faces a loss.

Again, the trader has a few options:

• Physical settlement: They can buy the 10 BTC at the agreed $90,000 and then immediately sell it on the market for $85,000, incurring a $50,000 loss.
• Cash settlement: They can pay the difference between the contract price ($90,000) and the market price ($85,000) per BTC, resulting in a $50,000 loss.
• Closing out the position: The buyer can sell an offsetting futures contract at the market price of approximately $85,000, realizing the $5,000 loss per BTC ($50,000 total).

In essence, futures trading is about predicting future price movements. If the prediction is correct, the buyer profits by closing their position at the higher market price or through cash settlement. In contrast, if the forecast is wrong, incur a loss when closing the position or through cash settlement.

The same applies to the seller — they can close the position before expiry if they find it an advantageous deal.

Can buyer and seller avoid their fulfillment?

Futures contracts do not have a “let it expire” option like in options trading. This means both the buyer and the seller of a futures contract can avoid fulfilling the contract by closing out their position before the expiration date. This is done by entering an offsetting trade: 

• The buyer can sell an equivalent futures contract. 
• The seller can buy an equivalent futures contract.

By doing this, they “cancel out” their obligation to pay the contract, and the price difference between the original contract and the offsetting trade determines their profit or loss.

Bitcoin futures ETF, explained

A Bitcoin futures ETF is a type of investment fund that invests in Bitcoin futures contracts instead of directly holding BTC. 

This kind of exchange-traded fund (ETF) provides exposure to Bitcoin price changes by tracking Bitcoin futures contracts, eliminating the need for investors to directly purchase, hold or manage the underlying cryptocurrency and its associated complexities.

Consider it as placing a bet on the future value of Bitcoin via a regulated fund. You’re investing in how the price of Bitcoin is predicted to fluctuate based on the futures market rather than actually owning it. 

For instance, the value of an ETF increases when the underlying futures contracts rise in value, often driven by the expected growth in Bitcoin’s price. This allows you to benefit from Bitcoin’s success indirectly, without the need to manage the risks and complexities of securing or handling your own wallet.

Now, you might be wondering: How do Bitcoin futures contracts differ from Bitcoin futures ETFs?

The table below highlights the key distinctions between the two.

How does a Bitcoin futures ETF work?

A Bitcoin futures ETF tracks Bitcoin’s price movements by purchasing Bitcoin futures contracts, which reflect the value of Bitcoin without direct ownership, and includes the process of rolling contracts when they near expiration, affecting the ETF’s performance.

Let’s break down how a Bitcoin futures ETF works step-by-step with an example, assuming Bitcoin’s current price is $93,425.

The ETF buys futures contracts (let’s say in January)

• A Bitcoin futures ETF is created. Its goal is to track the price of Bitcoin. Instead of buying actual BTC, the ETF manager buys Bitcoin futures contracts. Let’s assume they buy contracts that expire in April at a strike price of $95,000 (meaning whoever buys the contract has the right to buy Bitcoin for $95,000 at the April expiration). This is a simplified example; contracts have standardized amounts.
• The ETF uses the money invested by its shareholders to buy these contracts.
• Buying this contract costs a certain amount, called the “premium,” which is influenced by the current Bitcoin price, the time until expiration and market expectations. For simplicity, let’s assume the premium is $2,000.

Scenario 1: Bitcoin’s price increases to $100,000 

• Let’s say that over the next month, the spot price of Bitcoin will rise to $100,000.
• Because the futures contract gives the ETF the right to buy Bitcoin at $95,000, the value of that contract increases. It’s now worth more than the $2,000 premium paid because the ETF can buy Bitcoin at a lower price than the current market price.
• This increase in the value of the futures contract is reflected in the ETF’s share price. If the ETF holds many of these contracts, the overall increase will be distributed among the ETF’s shares.

Scenario 2: Bitcoin’s price drops to $90,000

• Now, let’s imagine the spot price of Bitcoin decreases to $90,000.
• The value of the ETF’s April futures contracts decreases. The right to buy Bitcoin at $95,000 is now less appealing since you can buy it on the open market for $90,000.
• This decrease in the value of the futures contract is reflected in a decrease in the ETF’s share price.

Rolling contracts 

• Remember, futures contracts have expiration dates. As the three-month expiration date of the example contract approaches, the ETF manager must do something. They can’t take delivery of the Bitcoin (the ETF isn’t designed to hold actual Bitcoin).
• The ETF manager performs a “roll.” This means:
  • Sell the expiring contract: They sell the contract that gives them the right to buy Bitcoin at $95,000 in three months.
  • Buy a new contract: They immediately buy a new contract with a later expiration date — e.g., six months out. Let’s say this new contract gives them the right to buy Bitcoin at $96,000 (slightly higher due to the time difference).

The cost of rolling

• Notice that the new contract has a higher “strike price” ($96,000 vs. $95,000). This difference represents a cost to the ETF. This cost, along with other administrative fees, is why the ETF’s performance might not exactly match Bitcoin’s spot price. This difference is called “contango” when future prices are higher than spot prices. If future prices are lower, it is called “backwardation.”

Throughout this process, shares of the ETF are traded on stock exchanges. Investors can buy and sell these shares just like any other stock. This is the key advantage: Investors get exposure to Bitcoin’s price movements without needing to:

• Set up a cryptocurrency exchange account
• Worry about securely storing Bitcoin in a digital wallet.

How to invest in a Bitcoin futures ETF

Investing in a Bitcoin futures ETF is straightforward and works similarly to buying shares of any other ETF. 

The key steps involved in investing in a Bitcoin futures ETF include:

• Open a brokerage account: If you don’t already have one, register with a traditional brokerage or use an investment app that provides access to ETFs.
• Fund your account: Deposit funds into your brokerage account so you can buy shares.
• Search for the ETF: On your trading platform, search for the Bitcoin futures ETF using its ticker symbol, such as “BITO.” Specifically, BITO refers to the ProShares Bitcoin Strategy ETF. 
• Place your order: Make a buy order after determining how many shares you wish to purchase and reviewing the current price.

Key considerations before investing

• Examine the ETFs that are available: Since each Bitcoin futures ETF may have various features or approaches to tracking Bitcoin futures contracts, compare them.
• Verify the expense ratios: Examine each ETF’s annual fees (expense ratios) because lower fees translate into more money staying in your pocket.
• Understand the volatility: Because Bitcoin’s price is subject to large swings, the value of the ETF is likely to follow market trends.
• Establish objectives: Ensure the ETF fits your risk tolerance and investing objectives.

Did you know? BITO was the first Bitcoin futures ETF to be approved in the US, launching in October 2021.

Benefits of Bitcoin futures ETFs

Bitcoin futures ETFs provide several advantages, making them an appealing option for investors looking to gain exposure to Bitcoin without directly buying or holding the cryptocurrency.

Let’s understand what those pros are:

• Accessibility: Compared to buying Bitcoin directly, investing in Bitcoin futures ETFs is considerably simpler. Using cryptocurrency exchanges, keeping track of private keys or protecting a digital wallet are not necessary. As with any conventional ETF, you can purchase shares through a brokerage account.
• Regulation: Bitcoin futures ETFs are regulated by agencies such as the SEC and traded on conventional stock markets. When compared to the mostly unregulated crypto industry, this degree of regulation provides investors with more protection and transparency.
• Liquidity: During regular business hours, buying and selling shares in Bitcoin futures ETFs is straightforward. This allows investors to quickly enter or exit their positions without dealing with the often more complex and slower processes associated with cryptocurrency exchanges.
• Familiarity: As these ETFs function similarly to typical exchange-traded funds, they are a viable choice for traditional investors who are already acquainted with investing in stocks or ETFs.

Risks and considerations

Although Bitcoin futures ETFs provide regulatory control and accessibility, investors should be aware of the risks, such as tracking error and volatility, among others.

Here’s a bit more detail on these risks and considerations:

• Tracking error: Tracking error is the difference between the performance of an ETF and the asset it tracks. Since Bitcoin futures ETFs don’t directly hold Bitcoin but follow Bitcoin futures, their performance can sometimes differ from Bitcoin’s actual market price.
• Contango and backwardation: These are important futures market factors that may affect profits. When contracts are rolled over, there may be losses since futures prices are higher than the spot price in a contango. Conversely, futures prices are lower than the market price during backwardation, which can increase returns. Depending on the state of the market, these characteristics can either improve or degrade ETF performance.
• Volatility: The value of the ETF can change significantly due to the continued high volatility of Bitcoin and its derivative products. As a result, Bitcoin futures ETFs are a high-risk investment that might not be ideal for risk-averse individuals.
• Fees: Management fees (cost ratios) are imposed by Bitcoin futures ETFs, which lower total returns. These expenses can mount up over time, especially in a volatile market where profits are unpredictable.

Investors should carefully consider these risks and ensure the ETF fits their risk tolerance and financial objectives.