Covered calls explained — conservative options strategies

okx learn
OKX Learn
2022.06.30

Covered calls are oft-used and conservative options strategies primarily used to generate income through price premiums. Market participants who utilize covered calls generally do so because they believe a cryptocurrency’s price is unlikely to see a substantial price increase in the short term.

As is the case with many options strategies, covered calls are mostly used by market professionals and advanced traders. However, retail investors — provided they have the funds to do so — may also use them.

To have a covered call, a market participant must be holding a long position in a cryptocurrency while selling call options for the same size of the same coin or token. As a conservative strategy, profit potential is limited — particularly when compared to merely leveraging a long or short position.

However, “conservative” does not necessarily equate to safety, in this regard, as cryptocurrency price decreases will still likely cause losses for the call seller.

How do covered calls work?

Covered calls are certainly not unique to the cryptocurrency market. Instead, they originated in the stock and futures market, where an owner of stock or futures contracts maintains the right to sell at any time for the current market price.

These owners may transfer this right — not the stock or futures contract, themselves — to another investor/trader in exchange for cash. The buyer then has the option (hence the term) to take ownership of the stock or futures contract on or before a predetermined expiration date for a predetermined strike price. This is called a “call option.”

A “covered call” is when the seller of the option also owns the underlying cryptocurrency (in our case), as they would not need to purchase the coin or token on the open market in order to fulfill their obligation.

How do covered calls make money?

Call options are primarily profitable for their sellers because of a premium that must be paid by the buyer — because the buyer is the one receiving the flexibility to actually buy the cryptocurrency at a predetermined price or not. The seller gets to keep this premium, no matter what.

The most-profitable scenario for the call-option seller is if the cryptocurrency price movement renders the call option worthless — so the premium essentially equates to free money.

However, in most cases, covered calls limit the amount of upside the seller can achieve and may be less profitable than if the seller simply held on to the cryptocurrency — assuming it sees a substantial upward price movement. Still, the cash premium paid by the buyer helps offset some of the downside risk.