What is a Covered Call?

A call option give the buyer the right, but not obligation, to buy a set amount of an asset at a set price. A covered call is a standard call option, which is backed with a spot position. Lets use the example from our previous article, What Are Options? 

Leo buying an ETH call option from Bill:

  • Leo pays Bill $200 now, for the right to buy 1 ETH for $3,000 in 1 months’ time.
  • Leo wouldn’t be forced to buy it (unlike futures), so if the price goes down, he only loses the premium.
  • If Leo wants to buy it, Bill must sell it to him at the set price. If ETH goes up to $5,000, Leo has made a $1,800 profit.

Now, to make it a covered call option, before selling Leo the option, Bill would buy 1 ETH on the spot market. That would lock in the price that ETH is currently at, and make sure that Bill has 1 ETH to sell Leo if he exercises the option.

Why Covered Calls?

Traders commonly use covered calls to generate yield on their crypto holdings. Rather than buying 1 ETH, they put aside or lock up 1 ETH they already hold to cover the option.

The trader collects a premium for selling the call option, whilst maintaining their long spot position on the underlying asset.

The risk is that they have to sell their crypto position (or settle the cash amount due, depending on if the options are physically or cash settled) if the price rises above the calls strike price (the price the option seller agrees to sell the asset to the buyer for).

Physically settled – when the option is exercised, the seller delivers the actual asset to the buyer, for the strike price. PsyOptions is a physically settled options exchange.

Cash settled – when the option is exercised, the seller pays the buyer the difference between the strike price, and the current asset price. Zeta Markets is a cash settled options exchange.

When using DeFi Options Vaults (DOVs), you don’t need to worry about if the options are physically or cash settled, as this will all be handled by the DOV behind the scenes.

Covered Calls in DeFi Options Vaults (DOVs)

Covered calls are used in DOVs as the standard, as they remove any risk that the seller, and the protocol, won’t be able to meet their obligations.

The process of selling options in a DOV is incredibly easy. You simply deposit and lock up the underlying asset (this is the ‘covered’ part), then the vault will use this as collateral, and go and sell the options for you.

DOVs take care of all admin when it comes to selling the option, including settlement, so you can deposit and leave, and the protocol will automatically roll over your deposit into the next set of options once one is over (unless you request it not to).

Covered Call Payoff

The seller hopes the price will remain below the strike price. As you can see in the chart above, once the asset goes above the strike price, returns go down.

This would mean the buyer doesn’t use (exercise) the option, and buy the asset off the seller. The seller then keeps the asset, and the premium (the amount the buyer paid for the right).

The buyer is paying for the opportunity to buy the asset, so they hope that the price will skyrocket, and they can buy the asset for a massively reduced price, earning instant profit. If the price at expiry isn’t at or above the strike price, the buyer loses the premium, and has nothing to show for it.

The optimal situation for the seller: the assert price rises to just below the strike price, as they will benefit from a modest rise in the asset price, and keep the premium.

If the price of the asset falls, the seller will lose USD value, as they are holding the asset as collateral. However, they earn the premium. If they would be holding the asset anyway, then they have turned a profit.

Selling covered calls is a great strategy for times of low volatility, or bear markets if you would be holding the asset anyway.

Yields Earned

Katana is an example of a DOV. It advertises projected Annual Percentage Yields (APYs) between 20-60%, with most falling between 20-30%. It is important to note, that these returns are not guaranteed, and there is a risk of loss.

Risks

Deposits into DOVs can suffer losses

Deposits into DOVs can suffer losses.

Generally, they sell far out-of-the-money options, for example, a call option with a $110 strike price when the price is $80.

If the price jumps to $120 before expiry, the buyer would exercise the options and buy the asset, which would result in a loss of $10 for the seller (minus the premium earned) when compared to buying and holding the asset.