DOPEX ESSENTIALS: COVERED CALL
What Is a Covered Call?
A covered call refers to a financial transaction in which the investor selling call options owns an equivalent amount of the underlying asset. To execute this an investor holding a long position in an asset then writes (sells) call options on that same asset to generate an income stream. The investor’s long position in the asset is the “cover” because it means the seller can deliver the shares if the buyer of the call option chooses to exercise. If the investor simultaneously buys an asset and writes call options against that asset position, it is known as a “buy-write” transaction — Investopedia
HOW DOES A COVERED CALL STRATEGY WORK?
Executing a covered call strategy
- Purchase the underlying asset.
- Sell call options against the underlying asset that you’ve purchased.
A covered call strategy is a popular strategy but it is usually viewed as low risk compared to other strategies. This is because when using a covered call strat, the loss you can experience is limited compared to other strategies where your potential loss is theoretically infinite.
With a covered calls, the worst-case scenarios are:
- You have to sell all the “shares” that you own.
- The “shares” you own lose all of their value minus the premium you earned.
In both cases, the potential loss is finite.
With a covered call strategy, you’re not just protecting yourself from losing money. You’re also placing a limit on how much you can earn from an increase in the underlying asset price. In exchange, you receive income in the form of the premium paid by the option buyer.
EXAMPLE OF A COVERED CALL STRATEGY
Holy Pepperoni buys 100 ETH at $50 each, for a total value of $5,000. He expects ETH to rise, and sells an options contract with a strike price of $55 to Push. Push pays a premium of $20 for this call option.
Scenario 1
If the price of ETH doesn’t rise above $55, Push is unlikely to exercise the option; and it would then expire. When that happens, Holy Pepperoni gets to keep his ETH and pocket the $20 premium Push paid him. His total profit or loss would be be $20, +/- any changes in the price of ETH from when he bought it at $50 per ETH.
Scenario 2: The ideal Scenario
ETH rises in value to exactly $55 at expiry, but Push does not exercise his option. If this happens, Holy Pepperoni gets to keep the $20 he received from Push and his initial 100 ETH which is now worth a total of $5,500. Combined with the $20 premium, Holy Pepperoni’s total gain is $520.
Scenario 3: Worst Case
If ETH drops to $0, Holy Pepperoni will lose his initial investment of $5,000. However, he will get to keep the $20 premium Push paid. That would put Holy Pepperoni’s total loss at $4,980 ($5,000–$20)
Scenario 4:
If ETH increases to $60, Push can exercise the option. He’ll pay Holy Pepperoni $55 per ETH. Holy Pepperoni will then keep the $20 premium and receive $5,500 from Push for the 100 ETH he sold. That would make his overall profit $520. However, he would lose out on potential profits, because if he had just held and sold his ETH at $60 each. He could have made a $1,000 profit instead of just $520. But the call option he sold to Push forces him to settle for just $55 per ETH, plus the $20 premium.
ANOTHER COVERED CALL EXAMPLE
Bruce owns some rDPX and likes its long-term prospects as well as its current price but feels that in the shorter term rDPX will likely trade relatively flat, perhaps within a couple of dollars of its current price of $25.
If Bruce sells a call option on rDPX with a strike price of $27, he will earn the premium from the option sale but, for the duration of the option, cap his potential upside to $27. Assume the premium he receives for writing a one month call option is $0.75 ($75 per contract).
Scenario 1:
rDPX trades below the $27 strike price. The option will expire worthless and Bruce will keep the premium from the option. In this case, by using the buy-write strategy Bruce has successfully outperformed the underlying asset. He still owns the invested rDPX but has an extra $75 in his pocket minus fees.
Scenario 2:
rDPX trades above $27. The option is exercised, and the upside is capped at $27. If the price goes above $27.75 (strike price plus premium), then Bruce would have been better off just holding rDPX. Although, if he planned to sell at $27 anyway, writing the call option gave him an extra $0.75 per rDPX
CONCLUSION
If you are a long term investor and want to generate extra income from your holdings, then covered call is a good strategy for you. As long as you pick the right asset to sell the option on and a good strike price.
Simple covered calls work best, so long as the price of the underlying asset stays below the strike price of the contract. It also provides a slight limit on potential losses, as you can not lose the premium you receive from selling the option. The primary risk of the strategy is that you miss out on gains if the value of your investments jumps too quickly.
If you’re ready to dip your toes into options trading, covered calls might be a good way to start. In some cases, selling a covered call may prove to be more profitable than owning the underlying asset.
KEY TAKEAWAYS
- To execute a covered call, an investor holding a long position in an asset then writes (sells) call options on that same asset.
- A covered call is a popular options strategy used to generate income in the form of options premiums.
- Covered calls are low-risk because you own the “shares” involved in the option.
- This strategy is ideal for an investor who believes the underlying price will not move much over the near-term.
- In the worst-case scenario, you lose out on potential gains past the strike price of the call contract.
About Dopex
Dopex is a decentralized options protocol that aims to maximize liquidity, minimize losses for option writers and maximize gains for option buyers — all in a passive manner. Dopex uses option pools to allow anyone to earn a yield passively. Offering value to both option sellers and buyers by ensuring fair and optimized option prices across all strike prices and expiries. This is thanks to our own innovative and state-of-the-art option pricing model that replicates volatility smiles.
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