The Rise of Bitcoin: A Source of Yield
This is not financial advice. Please note, these examples are purely theoretical in nature, and this article is not an endorsement or recommendation of these strategies. Do your own research.
Eleven years and more than six hundred thousand blocks ago… Satoshi bestowed upon us a financial revolution unlike anything in the history of humankind. Few realized it at the time, but now, with each passing block, Bitcoin gets stronger, and more and more naysayers become Bitcoiners.
Scholars will look back on this era and fill pages upon pages with their thoughts and analyses, but they will not characterize this time as “The Death of Fiat.” Rather, they will hail it as the “Rise of Bitcoin.”
We are, without a doubt, amidst a mass conversion to a world denominated in Bitcoin. Take these religious overtones with a grain of salt, but investors are becoming increasingly focused on Bitcoin-denominated gains, foregoing the antiquated mental model obsessed only with how much Bitcoin’s price can appreciate versus the dollar. In fact, many American Bitcoiners transitioned away from their mental dollar denomination in part because of their displeasure with the current “religion” of the Federal Reserve, issuer of USD.
We have entered the era of dual-denominated approach to portfolio management, in which investors measure profits and losses in both BTC and USD terms.
In Tantra Labs’ BTC Denominated Portfolio Management & the Structure of Bitcoin Interest Rates, we identified several ways to generate a Bitcoin-denominated yield by using Bitcoin as collateral: exchange lending, depository instruments, Lightning Network routing, and as collateral for derivatives trading.
In this piece, we will take an inside look at one specific derivatives strategy — selling covered calls — and how that strategy is front and center in the exploration of dual-denominated portfolio management.
Call Options
A call option gives the buyer the right, but not the obligation, to buy an asset, in this case Bitcoin, at a specified price within a specific time period. Here’s an example, from a USD perspective (spot price of BTC as of this writing is ~$8,000, options data is from Deribit): a call option to buy 1 BTC at a $20,000 strike price expires on September 25th, 2020. The price of this call option is $480. That means the buyer pays a “premium” of $480 for the right to buy 1 BTC at $20,000 on 9/25/2020. If Bitcoin’s price rises to $25,000, the owner of the call can “exercise” the option, pay $20,000 for 1 BTC, sell it for $25,000, and realize a $5,000 profit. Or, the investor could just keep 1 BTC. The seller of the option sells 1 BTC for $20,000 (instead of at the market price) and collects $480 in premium. As we begin to see, profits and losses are happening simultaneously in two denominations, BTC and USD.
Which denomination should investors target for returns? It depends, and each investor will prioritize gains and losses differently for each denomination.
The BTC perspective
Let us now think about these trades from a BTC perspective. Deribit, a cryptocurrency derivatives trading platform, only allows BTC as collateral, not USD. Example: a call option to buy 1 BTC at a $20,000 strike price expires on September 25th, 2020. The price of this call option is 0.057 BTC. If Bitcoin’s price rises to $25,000, the owner of the call can exercise the option, and take delivery of 1 BTC for only $20,000. The seller of the option is forced to sell that 1 BTC for $20,000 instead of the market price of $25,000, and retains the 0.057 BTC original premium collected.
The Dual perspective
We can make some assumptions about the buyer of these call options. He or she is essentially looking for a cheaper way to acquire Bitcoin versus buying at market price. Now, take the perspective of our covered call seller, Alice, as she thinks about her strategy in both denominations. She owns 5 BTC, and decides to post 1 BTC as collateral to Deribit. She can now sell a “covered” call, which means she actually owns the 1 BTC she would have to deliver in case the contract is exercised.
In other words, she is not taking any leverage. She collects a premium of 0.057 BTC and keeps the 1 BTC posted as collateral as long as the price doesn’t rise above $20,000. Her worst-case scenario, selling 1 BTC for $20,000 if the price is above that amount, is an acceptable risk to her, partly because her remaining BTC holdings will show phenomenal USD-denominated gains in that scenario. She is taking a dual-denominated approach to portfolio management because her worst case scenario in BTC terms is actually a very profitable scenario when expressed in USD-denominated terms. If Bitcoin’s price doesn’t explode, she gets to keep the premium and her original 1 BTC that was posted as collateral.
A Source of Bitcoin Yield
Collecting options premiums by selling covered calls is a form of Bitcoin income. This strategy alters the overall Bitcoin-denominated return profile for a Bitcoin holder. Alice reduces her exposure to parabolic upward price movements, but she trades that exposure for a stream of income in the form of BTC-denominated options premium. The yield, in this example, would be over 7% annualized, earned in BTC.
Large equity holders regularly employ such a strategy: if an investor owns several million shares of a leading technology company, selling covered calls against those shares gives the investor a nice income boost from options premium, foregoing any upside beyond the option’s strike price. The investor is comfortable with such a strategy because he or she doesn’t mind sacrificing some of his or her ownership of the company, especially if that means the rest of his or her holdings are experiencing impressive price appreciation.
The covered call seller is similar to an insurance provider. Insurance providers collect thousands of smaller premiums but are exposed to large events that trigger insurance payouts. Options markets can be thought of in a similar way: covered call premiums might be collected along the way, but if the price of Bitcoin explodes, the seller will have to payout in the form of relinquishing Bitcoin for a discounted price when buyers exercise their call options.
Bitcoin is Productive Collateral
Bitcoin has been deemed a commodity by the CFTC and property by the IRS, but as the financial ecosystem around it evolves, Bitcoin is starting to resemble multiple asset classes at the same time.
In this case, Bitcoin’s options markets resemble features of the equity options market, especially from the perspective of dual-denomination. Large shareholders think both in terms of USD profit/loss and in terms of total percentage ownership of companies. Their strategies in options markets mirror what a large Bitcoin holder might consider to generate income from the asset they hold.
This strategy is ideal for sideways markets and also a decent way to compliment USD-denominated losses if the price of Bitcoin declines. It is a way to turn the hype cycle of Bitcoin, specifically the thirst for exposure to parabolic rises (of which we’ve had several in Bitcoin’s short 11 year history) into cash.
The demand for such exposure, is strong in the market, evidenced by record Bitcoin options volume. Holders of Bitcoin can consider risking some of their Bitcoin in order to monetize that demand, and use their Bitcoin collateral in order to generate more Bitcoin by selling call options and collecting BTC-denominated premium.
For more from Nik Bhatia, check out The Triumvirate of Liquidity, Global Trends to Watch in 2020 , and you can also follow him on Twitter.
For more about Tantra Labs, check out our introductory post here.
For a list of beginner Bitcoin recommendations, check out this article.
For the latest updates from Tantra Labs, follow us on Twitter @Tantra_Labs.
Don’t forget to give us your 👏
Author’s opinion only. The views and opinions expressed in this article are those of the author and do not necessarily reflect the position of Tantra Labs Inc. or any other company. Examples of analysis performed within this article are only examples. They should not be utilized in real-world investment decisions as they are based only on very limited information. Assumptions made within the analysis are not reflective of the position of Tantra or any company.
Non-reliance. The information set forth herein is for information purposes only and should not be relied on or construed as investment advice, counsel, or solicitation for investment in Tantra or any other company. Interested investors should seek appropriate independent professional legal, investment, and tax advice prior to relying on any of the material contained in this article.
Forward-looking statements. Certain information set forth herein contains forward-looking statements that give a reader the opportunity to understand the author’s beliefs and opinions with respect to the future. These statements are not guarantees of future performance of Tantra or any other company and undue reliance should not be placed on them, as they necessarily involve known and unknown risks and uncertainties.
Not a securities offer. This article does not constitute an offer of securities by Tantra or any other company.
