Covered call is an option strategy that involves buying a call option and simultaneously owning the underlying asset, which are cryptocurrencies, especially Bitcoin.
Understanding Options Trading
Options trading on cryptocurrency grants the holder the right but not the obligation to purchase in a call option and the right but not the obligation to sell in a put option on an underlying cryptocurrency at a pre-decided price known as the strike price (X) on or before a pre-specified date known as the expiration date abbreviated as ‘t’.
Rather than holding the actual asset, traders trade on the value fluctuations of the underlying cryptocurrency. If the option buyers believe that the prices will rise, they will buy call options, and if they believe that the prices will move in the opposite direction, they will buy put options.
The advantage of this approach is that it limits the possible losses with unlimited profit at the payment of a nominal premium. It can result in profits if the price moves in either direction. The premium on the option is driven by volatility, time to expiry and the prices of the underlying asset.
However, option trading is complex and risky, with the comprehension of risk management techniques and market dynamics.
The key terms involved in option trading are:
Premiums
are the amount that an option seller receives in return for writing the option.
Strike Price
It is the decided price at which the buyer and seller agree to buy or sell the underlying asset at the time of exercise.
Expiry Date
It is the date at which the option must be exercised.
Covered Call Strategy
In options trading, a covered call option strategy is a popular method where an investor sells a call option on the underlying asset while simultaneously owning the underlying asset.
The two main parts of the covered call strategy are selling a call option and holding the underlying asset. The purpose of this strategy is to profit from any increase in the price of the underlying asset as well as from the premiums earned from the sale of call options.
To build the strategy, the trader’s portfolio needs to have a specific quantity of the cryptocurrency in it. It ensures their capability to fulfill the obligation, should the option be exercised. Then, the seller sells a call option, which provides them the right to buy cryptocurrencies within a given time frame on or before the expiration date at a strike price.
The option seller earns an upfront premium on the sale of the option. The option can also expire worthless, and he gets to keep the premium as a profit if the underlying trades below the strike price at the time of expiry.
The option could be exercised, and it requires the trader to sell the cryptocurrency at the pre-specified prices if the underlying price trades above the strike price. The trader’s potential gains are capped at the strike price of the underlying asset. They can additionally benefit from the premium they received.
Working Of Covered Calls
To understand the working of covered calls, let us assume that the reference price of Bitcoin is $70,000. Now, if a trader owns 1 BTC in his long portfolio and then decides to execute a covered call option. At the beginning of a covered call strategy, the trader needs to consider two factors: the strike price of the call option and the expiry date of the call.
These two factors, in addition to a few other factors, influence the option greeks. Option greeks majorly include theta, gamma, rho, and delta. However, an explanation of these greeks is out of the scope of this blog. These option greeks collectively determine the premiums on the option that an option writer receives.
Determination Of Strike Price
If a trader has a low risk appetite, covered calls are usually executed with a 30% margin of safety. It would equate to writing a call contract with a strike price of about $80,000.
If the trader is willing to take on more risk at the cost of selling BTC at a lower strike price, they can choose to execute a covered call strategy with a margin of safety of 15% to receive higher call premiums. It would translate to writing a call option with a strike price of $75,000.
Determination Of Expiry Date
It is important for traders to understand the impact of expiry dates on option premium. It is also crucial to understand that the options with a closer date to expiry (DTE) are cheaper than the longer DTE.
For conservative and passive crypto traders, they can write contracts that have more than 30 DTE. Their expiration date is 30 days ahead so there is enough time to repair the trade and roll their options if the prices are moving in the opposite direction.
Option traders generally keep up with the crypto market and take advantage of short-term volatility. They need to consider writing contracts on a weekly basis instead. Call contracts with an expiration date of five or more days tend to be more volatile so it allows for speculation on the price of their underlying assets.
If the trader is expecting much more price movement from an upcoming news item, they can take the opposite end of the trade by writing a call.
Conclusion
Covered calls are one of the most popular strategies that can help protect their portfolio holdings against the evolving world of cryptocurrencies. It combined the strategies of holding and selling covered calls so the option buyer could enjoy the benefits of both long-term potential and risk management.
FAQs
What are the risks involved in a covered call strategy?
The risks are related to the unstable and rapidly evolving crypto landscape. Its risks are related to opportunity costs.
What are the benefits of participating in a covered call?
It offers multiple ways to generate income, enhance returns in some prevailing market conditions and also helps in diversifying some of the risks.
When not to be involved in a covered call?
When the traders have bullish views in the near future, the covered call should not be used. In the expectation of serious downsides, a trader should avoid buying covered calls.
