Bitcoin Futures ETFs Explained: The Ultimate Guide

Bitcoin futures contracts, explained

A prearranged deal for buying or selling goods like wheat, oil, or Bitcoin at a fixed price in the future is called a futures agreement.

These agreements serve a dual purpose – they can be utilized for safeguarding against potential losses (risk mitigation or hedging) and for making strategic bets on price fluctuations (speculation). To illustrate, imagine you own a farm and the prices of your crops have been unpredictable. You could use these contracts to protect yourself from significant drops in crop prices by agreeing to sell your crops at a fixed price in the future (hedging). On the other hand, if you believe that crop prices will increase in the near future, you might choose to speculate by buying these contracts and profiting from any rise in prices.

Picture a miner (vendor) anticipating to mine 10 Bitcoins (BTC) within the next three months. To protect against a potential price decrease, the miner agrees to sell these 10 BTC for $90,000 each in three months through a futures contract. This guarantees a revenue of $900,000 regardless of Bitcoin’s market price at that time. This strategy is often used as a form of protection or hedging.

A Bitcoin investor (purchaser) is confident that the value of Bitcoin will continue to soar, and consequently, they have made an arrangement to acquire 10 Bitcoins in a span of three months, at a price of $90,000 per Bitcoin.

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

Should Bitcoin’s value reach approximately $95,000 within the next three months, the individual who purchased the futures contract at $90,000 stands to gain a potential profit. To capitalize on this opportunity, they can close their position by selling the futures contract before the expiration date, thus locking in the difference between the purchase and sale prices as their profit.

• 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).

At its core, futures trading involves trying to foretell the direction of future price fluctuations. If the prediction turns out to be accurate, the investor can make a profit either by selling their position at a higher market price or receiving cash settlement. On the flip side, if the prediction fails, the investor will incur a loss upon closing their position or through cash settlement.

Just as the buyer has the option to end their position prior to expiration if they come across a favorable opportunity, so too can the seller do the same.

Can buyer and seller avoid their fulfillment?

Unlike options trading, futures contracts do not allow for letting them expire without action. Instead, both parties involved in a futures deal can escape their obligation by closing their positions prematurely via opposite trades before the contract’s expiration date. This action is referred to as “offsetting” the trade.

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

Through this action, they effectively discharge their duty to fulfill the contract’s payment terms. The variation in cost between the initial agreement and the counterbalancing transaction decides their potential gain or loss.

Bitcoin futures ETF, explained

An Exchange-Traded Fund (ETF) focused on Bitcoin Futures operates by investing in contracts for future delivery of Bitcoin, rather than purchasing the actual cryptocurrency itself.

This type of Exchange-Traded Fund (ETF) allows investors to follow Bitcoin’s price fluctuations by mirroring Bitcoin futures agreements. This means that investors don’t have to buy, keep, or handle Bitcoin themselves, thus avoiding the intricacies that come with owning cryptocurrency directly.

Instead, you might think of it as wagering on the potential future worth of Bitcoin through a legally approved investment vehicle. Essentially, you’re putting your money into predictions about Bitcoin’s price movements in the futures market, not physically owning the cryptocurrency itself.

As a crypto investor, I can profit from Bitcoin’s growth indirectly by investing in Bitcoin-based Exchange Traded Funds (ETFs). These ETFs increase in value when the underlying futures contracts tied to Bitcoin appreciate, which is typically driven by anticipated increases in Bitcoin’s price. This strategy offers a convenient way to capitalize on Bitcoin’s success without having to worry about the risks and complexities associated with storing or managing my own digital 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?

An Exchange Traded Fund (ETF) that focuses on Bitcoin futures follows the changes in Bitcoin’s price by buying Bitcoin futures agreements. These agreements represent the value of Bitcoin without actual ownership, and the process of replacing contracts as they get close to expiration impacts the ETF’s overall performance.

Here’s an easier-to-understand breakdown of how a Bitcoin Futures ETF operates, illustrated with an example when Bitcoin’s price is $93,425:

Let’s explore the inner workings of a Bitcoin Futures Exchange Traded Fund (ETF) one step at a time, using an example where Bitcoin’s current cost is $93,425.

Step 1: An investor purchases shares in the Bitcoin Futures ETF through their brokerage account. These shares represent ownership of contracts that will buy or sell Bitcoin at a future date and price set today (known as futures contracts).

Step 2: The ETF provider buys these futures contracts on various exchanges, such as CME Group or Bakkt, to gain exposure to the underlying Bitcoin market. In our example, let’s say they buy contracts for 100 Bitcoins (approximately $9,342,500) at a price of $93,425 per Bitcoin.

Step 3: As time passes, the price of Bitcoin may rise or fall. If the price rises, the value of the ETF shares increases as well. Conversely, if the price falls, the value of the ETF shares decreases. In our example, let’s assume that Bitcoin’s price reaches $100,000 at a later date.

Step 4: The ETF provider sells their futures contracts for 100 Bitcoins at the new market rate of $100,000 each (for a total of $10,000,000). This results in a profit of approximately $657,500 ($10,000,000 – $9,342,500) for the ETF provider.

Step 5: The profits are then passed on to investors who own shares in the Bitcoin Futures ETF. The share price reflects this profit, and the investor’s portfolio value increases accordingly. In our example, if an investor owned 100 shares of the ETF, their investment would be worth approximately $9,942.50 more than when they initially purchased it.

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.”

During this procedure, Exchange-Traded Fund (ETF) stocks are traded on various stock markets. Much like regular stocks, these ETF stocks can be bought and sold by investors. The main benefit lies in the fact that investors can experience fluctuations in Bitcoin’s price without having to:

1. Directly possess Bitcoin themselves.
2. Deal with the complexities of buying, storing, and safeguarding Bitcoin.

• 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 Exchange-Traded Fund (ETF) is simple and functions much like purchasing stocks from any regular 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.

Have you heard? The BITO fund was the pioneer of Bitcoin future ETFs in the U.S., officially debuting in October 2021.

Benefits of Bitcoin futures ETFs

Investing in Bitcoin through ETFs that focus on futures offers multiple benefits, making it a tempting choice for those seeking Bitcoin exposure without the need to personally acquire or store the digital currency.

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

While Bitcoin futures ETFs offer regulatory oversight and ease of investment, it’s essential to understand the potential risks involved. These may include price discrepancies (tracking error) and high volatility, amongst other factors.

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.

Prudent investors ought to thoughtfully weigh these potential risks, making sure that the ETF aligns with their risk appetite and investment goals.