Generating Yield Through Trading BTC Options
DISCLOSURE: The ecosystem landscape included in this informational post is intended to provide generalized guidance; nothing in this analysis is intended as investment advice, a recommendation or an introduction to particular funding or capital resource.
Yesterday, we caught wind of an article on CoinTelegraph, written by Marcel Pechman, titled “Afraid of DeFi? Here’s how to earn 41% APY on Bitcoin without wrapping it”. In that article, Pechman laid out a case for generating yield on Bitcoin holdings not through DeFi applications but instead through the options markets. Here at Wave, we’re proponents of exactly that kind of strategy — for nearly a year now, our Wave BTC Income & Growth (WBIG) fund, designed to target an annual yield payout of 18%, has been paying out 1.5% monthly in yield (net of fees) through trading options.
Unfortunately, some of the story Pechman laid out when it comes to using the options markets to generate yield seems more confusing than useful, so we wanted to write a quick response explaining some of the ideas he presented. Overall, we want to offer kudos to Pechman for thinking about yield-generating strategies and connecting the options markets to the craze in yield farming applications, but we also think it’s important to be precise when discussing these things.
How Do Covered Calls Work?
In his article, Pechman describes a covered call strategy as consisting of “simultaneously holding BTC and selling the equivalent size in call options.” For selling the calls against your long BTC you receive the call premium, which is the price the buyer pays for the option to buy BTC at the strike price specified in the call option contract. The returns on a covered call strategy, then, depend on the premium you can generate.
Options premiums are difficult things to understand — Myron Scholes and Robert Merton won a Nobel Prize in 1997 for having figured out a reliable way to price them. But in general, the premium increases when the contract length is longer, when the difference between the price today and the strike price is smaller, and when BTC volatility is higher.
From there, you can guess that the most lucrative covered call strategies will be the ones that have contract lengths greater than a year (or more), that have strike prices equal to (or less than) today’s price, and that are created when BTC volatility is highest. You’d be right! At time of writing, a call option which expires in June of 2021 and is struck at $10,000/BTC offers an annualized premium of 34.66%. This is even considering BTC volatility is rather low these days compared to historicals.
However, it’s important to recognize the risks associated with different covered call strategies. An easy way to visualize the exposure you get when trading options is to look at profit and loss on your position versus where the BTC price ends up on the day the contract expires.
By way of comparison to just being long a stock, just being long a call is different because your downside is capped: you only ever lose the premium you paid for the call, but when the price of the asset is above your strike, you profit. A covered call is a position made by going long an asset and short a call option on that asset, so the combined profit and loss looks something like the below.
The exposure looks like a long asset exposure, with uncapped downside, until the strike price of the option. When the asset price is higher than the strike price at expiration, your call gets exercised and you sell your asset to the buyer. But because you owned the asset the entire time, this is not a loss in P&L terms, and so your upside exposure is merely capped.
The Trouble with Mr Peshman’s Proposal
Here’s where we run into some problems with Peshman’s article. He advertised, in comparison with DeFi-based yields, that “trading BTC options at Chicago Mercantile Exchange (CME), Deribit, or OKEx, an investor can comfortably achieve 40% or higher yields.” But when above we looked at essentially the best-case covered call we saw that its annualized premium reached 34.66%. What’s the difference?
Peshman bases that 40% number on one call contract expiring at the end of November 2020, whose price is struck at $9,500. This strike price is lower than today’s price for BTC, which is about $10,750/BTC. “As previously mentioned, the covered call might present losses if the BTC price at expiry is lower than the strategy threshold level….Any level below $8,960 will result in a loss, but that is 16.6% below the current $10,750 Bitcoin price,” he writes.
This, unfortunately, is a fundamentally mistaken way of thinking about covered calls. If you sell a call option whose strike price is below today’s price (or the price you expect the asset to hold at day of expiry), you must be ready to sell your asset at that lower strike price. Put another way, if you hold 1 BTC today, when the price is ~$10,750, and you sell a call against it at $9,000 to expire today, the lucky schmuck on the other side gets to make a free $1,750 when he buys the BTC from you at $9,000.
Peshman offers another set of strikes to consider, this time at $8,000 and $9,000, but commits a similar error in describing the profit and loss. “A 25% APY return can be achieved by selling 0.5 BTC $8K and 0.5 BTC $9K November call options. By reducing expected returns, one will only face negative outcomes below $8,370 at the November 27 expiry, 22% below the current spot price,” he writes, but this is again mistaken. Agreeing to sell at $8,000 when BTC is trading at $10,750, unless you have a real belief that the price at expiry will be below $8,000/BTC, is a negative outcome!
When you’re entering a covered call position, we believe you maximize your expected return when you leave a little room for upside performance in BTC. That’s why we at Wave favor selling about 20% higher than today’s price. What’s equally important, though, is the length of the option contract.
Trading options on a less than monthly basis introduces some extra risk due to liquidity. In general, the most liquid contracts are the monthly expiries, a pattern that holds equally as well in crypto markets as in traditional markets, like equities, commodities, and foreign exchange. Peshman sets his call to expire at the end of November, which is a two-month contract. That’s ok from a liquidity standpoint, but that length neither maximizes premium generated like a very long-dated contract would nor minimizes risk from length of contract like a one-month contract would.
For that reason, we favor a strategy that involves trading one-month options. The major benefit of trading covered calls monthly is that you reset your strike price every month. Selling calls 20% higher than today’s price is a dicier proposal if you have to wait two months or longer to reset, but when you’re resetting every month, your gains are also capped at 20% per month. Even BTC, the most volatile asset class by far, is rather infrequently growing by more than 20% per month. By contrast, 20% price moves over two months or longer are almost to be expected.
So while we appreciate Peshman’s contribution to the narrative on how to wring yield from your BTC exposure, there are better ways to implement a covered call strategy.
Important Disclosures and Other Information
This informational piece is intended to inform Wave Financial’s audience of the current status of the crypto industry. Nothing in this material should be interpreted as an offer or recommendation to buy, sell or hold any security or other financial product or service. Wave Financial LLC is a registered investment adviser, registered with the state of California. Registration with the state authority does not imply a certain level of skill or training. Additional information including important disclosures about Wave Financial LLC also is available on the SEC’s website at www.adviserinfo.sec.gov. Or, learn more information about Wave Financial at www.wavegp.com.
The ecosystem landscape included in this post is intended to provide generalized guidance; nothing in this analysis is intended as investment advice, a recommendation or an introduction to particular funding or capital resource.
