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The Craziest Bitcoin Investment Yet

Dan Caplinger, The Motley Fool

Cryptocurrencies are taking the investing world by storm, and the dramatic gains for bitcoin (BTC-USD) in the past year have made many investors greedy for ways to make money from the craze. Major financial institutions have sought numerous ways to make bitcoin more readily available to investors, such as bitcoin futures, and some have looked at exchange-traded funds with bitcoin as a way of opening up the cryptocurrency to the masses.

Yet Wall Street often goes too far with its ideas, and one proposed investment could make even bitcoin look tame by comparison. One financial company introduced the idea of leveraged bitcoin ETFs to the market earlier this month, adding the potential for even more violent price moves for its shareholders.

Bitcoin symbol on a golden disc, standing on end in front of a price chart

Image source: Getty Images.

NYSE, Direxion look at leveraged bitcoin ETFs

In a filing in early January, the New York Stock Exchange's NYSE Arca unit sought permission from the U.S. Securities and Exchange Commission to list and trade shares of new exchange-traded funds from Direxion Investments. The new ETFs all had the words "Direxion Daily Bitcoin" in their names, but each of the five ETFs offered different levels of exposure to the cryptocurrency. For those who are bullish on bitcoin, the 1.25X Bull Shares, 1.5X Bull Shares, and 2X Bull Shares seek to offer daily returns equal to 1.25, 1.5, or 2 times the daily return of a target benchmark of bitcoin futures contracts. Those who want to bet against bitcoin will be able to choose 1X Bear or 2X Bear Shares, which would try to produce returns equal to the inverse return or twice the inverse return of the bitcoin benchmark respectively.

The regulatory filing revealed many of the proposed characteristics of the Direxion ETFs. The funds would feature creation and redemption procedures just like any other exchange-traded fund, but they would seek to use bitcoin futures and options on those futures in order to track their daily performance goals. That's similar to the derivatives that most leveraged ETFs use to produce the intended level of leverage.

The new danger from leveraged bitcoin ETFs

The concept of leveraged bitcoin ETFs was likely inevitable, but there are many risks involved with the idea. First, even funds that don't use leverage in investing in bitcoin face risks, including the inherent challenges of handling cryptocurrency transactions, uncertainty about future legal and regulatory restrictions on bitcoin, the potential for further exchange-hacking events, and whether bitcoin will gain wider acceptance as a medium for everyday transactions. In addition, the SEC has been reluctant to give the go-ahead on unleveraged bitcoin ETFs, especially those relying on futures contracts that have traded for barely a month.

Yet even if you set aside all of the concerns about bitcoin and its viability as an investment vehicle, introducing leverage to the mix brings a completely different set of dangers to the table. Leveraged ETFs are inherently short-term in nature -- the term itself shows their suitability for only daily use. When you hold leveraged funds for longer than their stated investment period, you'll often find that dramatic volatility in the underlying asset's price can erode their value in ways that you wouldn't expect. In some cases, leveraged bull funds and leveraged bear funds in the same asset can both lose money over longer periods of time, due to the way that daily returns are calculated and to how leveraged ETFs reposition themselves to fulfill their stated investment objectives.

The fact that the ETFs will use futures introduces yet another element of uncertainty. If later-month futures have higher prices than current-month futures, then a bitcoin ETF will see slow but steady erosion in value from the pricing structure of that particular futures market.

Steer clear of leveraged bitcoin ETFs

At this point, it's unclear whether the SEC will allow any bitcoin ETFs to come to market, let alone leveraged ones. If they do become available, even ardent investors in bitcoin should think twice before buying shares of these funds. The huge levels of risk coming from multiple angles aren't worth taking on, simply for the ability to see even more dramatic rises and falls than what bitcoin will give you on its own.

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