BITO Is Now A Good Way To Track Bitcoin (NYSEARCA:BITO)

The ProShares Bitcoin Strategy ETF (BITO) uses Bitcoin futures to gain exposure to the price movement of Bitcoin. While it has not been a viable way of tracking Bitcoin, recent market observations show that it will be a good way for doing 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 hold for anyone who wants to gain exposure to Bitcoin through a liquid, centralized entity.

BITO Did Not Work Well in the Past Due to Contango in Bitcoin Futures

BITO’s holdings and prospectus show that it uses the short-dated CME Bitcoin futures, rather than actual Bitcoin, to gain exposure to the price of Bitcoin. Because CME Group is a highly respected derivatives exchange and its products are aligned with SEC regulations, a Bitcoin ETF based on CME’s futures was 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 steep contango, where futures traded above the spot price. Each time BITO needed to sell expiring contracts to buy the next month’s contracts, it had to do so at a price above the spot price. This is called a negative roll yield. Over time, a negative roll yield erodes the fund’s capital and produces a huge tracking error between the price of the spot and the NAV of the fund. Examples of this are the VIX funds which seek to track short-term VIX movements by purchasing VIX futures. The funds can never track the VIX for a long time because VIX futures are nearly always in contango, forcing these funds to incur a negative roll yield and erode capital each month.

For a while, Bitcoin futures exhibited a similarly destructive contango. This explains the underperformance of BITO relative to Bitcoin since the former’s inception in October 2021. In less than six months, just five instances of rolling the contracts, BITO has already underperformed by more than 2%.

(Source: Seeking Alpha Charting)

The Usual Reasons for Contango and Backwardation

Contango makes sense in the context of commodities. For example, oil futures are generally in contango. When someone sells a futures contract, they are promising delivery of that item on a later date. The higher future prices reflect the cost of them holding the physical oil, called the cost of carry. In most commodities, the cost of carry exists because it is inconvenient and costly to have to store physical commodities in large quantities.

Futures occasionally exhibit backwardation, where prices slope downward as time until expiration increases. This usually occurs when the physical commodity is experiencing a surge in demand, pushing the spot price above the future prices. Conversely, there may be a general expectation that supply will increase in the future, despite there being a shortage in the present. Naturally, this would be reflected by the spot price being high due to the shortage and the expected future price being lower due to an expected increase in supply. Another way of looking at backwardation is that the holder of the physical asset experiences carry cost that is beneficial to them. For example, if the future contract was on a stock which pays a dividend, then naturally the future price of the stock would be lower because the stockholder would have received a dividend before he had to deliver the stock.

The Bitcoin Basis Trade is Fading

A basis trade takes advantage of the discrepancy between spot and future prices. Assuming a commodity is in contango, one can buy the physical asset at the spot price and sell futures (which are at a higher price) to lock in a risk-free profit. The reason this does not work, and contango persists, is that to store the physical asset the trader would need 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 ledger is immutable. The coins are secured as long as the private key to the owner’s address is not known to others. To liquidate the Bitcoins, the owner can go to an exchange, use his private key to send the Bitcoin to a destination address, and receive USD. To buy Bitcoin, a trader simply does the reverse. This is a simple, inexpensive process. Bitcoin also does not generate cash flows or yield.

To summarize, the important difference between Bitcoin and other commodities is that Bitcoin should not have a carry cost. It does not pay dividends and it does not cost anything to store securely. There is a liquid market for it, and it is easily transferred between people. The source of contango or backwardation for commodities is not present in Bitcoin.

As such, the Bitcoin basis trade is very viable. Traders can easily lock in a risk-free profit by being long Bitcoin in the spot market and shorting it in the futures market. And this has been happening. The opportunity for this basis trade has diminished, and the futures curve is starting to resemble a straight line, albeit slightly upward sloping.

This can be seen in a time series of the spread between Bitcoin and BITO. When BITO first started trading, it consistently underperformed Bitcoin. This was because Bitcoin futures were in steep contango. Since late January, we see a lot more instances where Bitcoin underperforms BITO, such that on average neither is consistently doing better than the other. This is when the basis trade for Bitcoin futures was beginning to fade.

(Source: Yahoo! Finance for historical prices, calculations by Author via Excel)

Due to the nature of Bitcoin, I expect the future prices to generally be in line with the spot price. Anytime there is significant deviation, arbitrageurs will step in to earn a risk-free basis trade profit. Eventually, future price premiums should represent only the risk-free rate plus transaction costs and a risk premium which factors in the possibility of getting one’s coins stolen (which would be almost zero if the private keys are secured).

Considering BITO

If Bitcoin futures continue to stay in line with Bitcoin’s spot price, BITO will track the price of Bitcoin very well. The growing prevalence of cryptocurrencies means more and more eyes will be on this space looking for opportunities. This will naturally make the market more efficient. Because we have established that there is little cause of contango or backwardation for Bitcoin, the only source of tracking error would be the transaction fees from rolling monthly. Eventually, BITO managers may choose to buy futures of longer maturity to minimize this cost.

This makes BITO a good vehicle for tracking Bitcoin going forward. Furthermore, BITO’s liquid option chain 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 puts to collect income. Alternatively, shorting BITO or buying BITO puts will be a good way to bet against Bitcoin. While Bitcoin derivatives do exist on other exchanges, these alternatives are generally unregulated, which may not fit the risk tolerance of many investors.

Conclusion

BITO is a hold for anyone who wants Bitcoin exposure without the hassle of opening a separate account on a cryptocurrency exchange. The fact that it has an extremely liquid options chain makes it better than actual Bitcoin if one is looking to trade Bitcoin-related options in a regulated environment.