SUMMARY

• BITX is a daily resetting leveraged ETF.
• Leverage compounding may boost BITX performance.
• Volatility drag may dampen BITX performance.
• Download as a PDF.

On June 27, 2023, Volatility Shares launched the 2x Bitcoin Strategy ETF (Ticker: BITX), the first ETF to offer leveraged exposure to a cryptocurrency in the U.S. This article expands upon How BITX Works: The Basics.

BITX IS A DAILY RESETTING LEVERAGED ETF
BITX is structured as a leveraged, daily resetting ETF. BITX’s investment objective is to deliver twice (2x) the daily performance of short-term CME Bitcoin futures - specifically 2x the daily performance of the S&P CME Bitcoin Futures Daily Roll Index* (Ticker: SPBTFDUE). To maintain this daily 2x exposure, BITX buys or sells Bitcoin futures to reset its exposure back to 2x every day.

Like all daily leveraged ETFs, BITX exhibits two important characteristics known as leverage compounding and volatility drag. Leverage compounding may magnify the performance of the ETF beyond the expected 2x objective over periods of more than one day, while volatility drag has the opposite effect, and may dampen longer term returns. Whether BITX exhibits leverage compounding or volatility drag depends on the trend or mean reversion in Bitcoin futures daily prices. If daily prices are trending up, long term performance tends to outperform the daily 2x objective, while if daily prices are mean reverting, the long-term performance tends to lag the expected 2x objective. Let me explain.

LEVERAGE COMPOUNDING
Leveraged compounding in leveraged ETFs occurs when daily prices follow a trending path. For example, if the day-to-day price action is generally in one direction, then the rebalancing activity that BITX performs each day compounds the ETF’s daily leveraged returns and tends to cause the ETF to outperform the 2x daily objective over a longer period. For example, if Bitcoin futures were to trend up 10% a day for three consecutive days, then BITX’s performance could be calculated as = 1.2 * 1.2 *1.2 = 1.73, or a performance of around 73% over the three days. This is notably higher than the 60% gain some traders may expect by simply adding 20% over three days.

For leveraged funds like BITX, the larger the daily moves, the more pronounced this compounding becomes. For example, if Bitcoin futures were to rise 20% a day for three consecutive days, then BITX’s expected performance could be calculated as = 1.4 *1.4 * 1.4 = 2.74, or an impressive 174% increase over three days – a whopping 54% more than the simple sum of the three 40% returns (40% + 40% + 40% = 120%).

Put simply, daily leveraged ETFs like BITX may appeal to investors who believe Bitcoin futures will consistently trend upward over time.

VOLATILITY DRAG
On the other hand, volatility drag in leveraged ETFs occurs when daily security prices follow a noisy, up-and-down path. Because leveraged ETFs must rebalance their assets at the end of every day, if the day-to-day price action is noisy, that rebalancing activity may generate losses and cause the ETF to underperform its daily objective over a longer period. For example, if Bitcoin futures were to rise 10% on day one, fall 5% on day two, and then rise 7% on day three, the expected leveraged performance of a fund like BITX over the three days would be = 1.2 * 0.9 * 1.14 = 1.23, or 23%, while the simple sum of the leveraged daily returns +20% - 10% +14% = 24%. This 1% lag is due to volatility drag.

The magnitude of volatility drag depends on the magnitude of the daily reversals. For a 2x leveraged product like BITX, the average daily volatility drag may be approximated as the daily volatility of Bitcoin squared. If the daily volatility of Bitcoin was about 4%, BITX’s expected volatility drag could therefore be calculated to be around (0.04)^2 = 0.16%. If reversions like this were to happen every day, these losses may add up.

CONCLUSION
BITX may be best positioned for traders expecting an upward trend in Bitcoin futures prices, as BITX may offer leveraged exposure to Bitcoin futures of greater than 2x over periods greater than one day. On the other hand, if Bitcoin futures prices remain volatile within a range and do not trend upward, volatility drag may erode returns over longer periods.

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