Asteria Essentials #11 - Covered Calls
👋Hello Asterians,
This week we’re talking about covered calls — are you holding an asset? Putting up with volatility? Why not earn yields on it? That’s what makes covered calls so special.
The strategy is an all-time favorite for investors who are long on an asset that is most likely trading flat in the short run and keen on generating extra yields without selling their bag.
Let’s dive straight into it
What Is a Covered Call?
A covered call is a passive yield generation strategy where the option writer(seller) owns an equivalent amount of the asset underlying the call option that is being sold. The option seller must agree to give away the right to buy the asset at the established strike price to execute the transaction. So the seller who is long on an asset by virtue of holding writes the call option on the same asset to generate additional income.
The Strategy
The covered call strategy doesn’t employ token emissions or leverage since the seller fully collateralizes all options. The strategy is favored because it is generally viewed as a low-risk strategy. The risk exposure is fairly limited in a covered call strategy compared to other cases where the risk can be infinite.
Integrating European options with the covered call strategy means the option buyer can only exercise the option at expiry. The goal of selling this call option is to expire out-of-the-money, leaving the buyer with no incentive to exercise their option. This is where the yield comes from for the option writer, as they keep the entirety of their underlying collateral as well as the premium for selling the option.
Risk is Finite
For the option writer, the biggest risk is the option expiring out-of-the-money, allowing the buyer to exercise their options. This cannot be denominated as a loss per se, but more of underperformance vs. holding the asset because the seller is still exposed to the upside until it reaches the strike price.
Toy Example
Big Guy owns some $BVER tokens and likes its long terms prospects, but he also feels like for the short term, $BVER might run flat and perhaps within a few dollars of its current price of $50.
If Big guy sells a call option on $BVER, with a strike price of $52, he will earn the premium from the sale of the option. However, for the entire duration of the option, the Big guy’s upside potential is capped at $52. Let’s assume that he receives a premium of $75 for writing call options for a month.
There are two ways in which this strategy might play out for Big Guy:
Scenario 1 -
$BVER trades below the strike price of $52; then, the option expires out-of-the-money. The big guy keeps the premium for the call option. In this scenario, a simple buy-and-write has allowed Big Guy to outperform the underlying asset successfully. At the end of the day, he still owns his precious $BVER on top of the $75 minus the externalities.
Scenario 2 -
$BVER trades above $52 and the option is exercised, being capped at $52. Hence, if the price goes above (suppose to $52.75), Big Guy would profit more by simply holding $BVER. And even though he planned to sell at $52 anyway, writing the call option would yield him an extra $0.75 per $BVER.
Additional Option Writing Strategies
Put Selling:
Very similar to covered calls, the option writer sells an option hoping that it will expire out-of-the-money. The key difference is that, while selling the option, the option writer should also agree to buy an asset at a strike price below the current price. The bet is that the underlying asset does not fall below the said price, and the writer keeps the collateral and the premium paid for writing the option.
In this case, the strategy could also outperform the underlying asset. However, if the price of that asset falls below the strike price, the writer will end in a loss, as the condition was to pay the difference between the strike price and the asset price.
Short Strangle:
When an option writer sells both the covered call option and put option for the same asset with similar expiration dates but different strike prices. The strike prices of both the covered call and put act as the bounds so that in case the underlying asset is above the strike price of the put option and below the strike price of the call option, the seller is returned the entirety of their collateral along with the premium of both options being sold. This strategy is optimal for writers who are neither bullish nor bearish on an asset but instead leverage against a certain amount of asset volatility over the option’s lifetime.
When injected into decentralized options vaults, the same strategy could allow users to use the same collateral for both options.
Short Straddles
When an option writer sells both the covered call option and put option for the same asset under the same expiration date and strike price. For this strategy, an optimal scenario would be to expire exactly at the strike price, which means that both the options expire essentially out-of-the-money, and the writer receives their collateral back along with the premium earned on writing both options.
Salient to the short strangle strategy, the writer of the option is short volatility, but the risk of loss in short straddles is relatively higher since the writer is establishing a tighter range. However, the writer could earn more in premiums if the strategy is executed successfully in return for the additional risk exposure.
There are equally as many strategies for the buyer side. The option landscape is pretty exciting and scary for those who don’t have enough knowledge or experience. This is where Asteria comes in. In the long run, we aim to inject the largely complex strategies into easy-to-use products, say DOVs, that generate truly sustainable yields that do not flatten due to price inflation or dilute due to overcrowding.
This will be the end of Asteria Essential episode #11. See you soon in the next one!
