Cryptocurrency enthusiasts often find themselves in a dilemma — they want to HODL their digital assets for the long haul and find a way to protect their positions from market volatility. While HODLing can be a sound long-term strategy, it doesn't shield you from market downturns. This is where the covered call options strategy can provide some form of crypto portfolio protection over time.
In this article, we'll dive deep into the world of covered calls and how they can be a valuable strategy for hedging your crypto portfolio while you HODL against short-term volatility.
What are covered calls?
A covered call is a neutral options strategy that involves two parts: owning an underlying asset and the selling of a call option against said asset. In the case of cryptocurrencies, it involves owning an underlying coin or token and simultaneously selling a call option on this digital asset. By executing this strategy, crypto traders can receive downside insurance in the form of call premiums over time while HODLing their favorite cryptocurrencies.
To HODL or not to HODL
HODLing is all about maintaining a long-term perspective. Many crypto traders believe in the potential of their chosen digital assets to appreciate significantly over time. They hold their assets through market ups and downs, hoping for substantial gains.
While HODLing can be rewarding, it's not without its risks. Cryptocurrency markets are highly volatile, and prices can fluctuate dramatically. A sudden market crash can erode your crypto portfolio's value, leaving you with fewer gains or even losses. With an options strategy like covered calls in your arsenal, this volatility will be cushioned since you'll be credited with call premiums along the way while you're HODLing your crypto portfolio. This makes covered calls perfect for those who want to protect their holdings while still benefiting from potential price increases.
Why is the covered call options strategy so popular?
Do you already have a crypto portfolio you're intending to hold for a prolonged period? Simply write call options against the portfolio and you'll have executed the covered call strategy. As the bread-and-butter options strategy for many crypto HODLers, covered calls are essentially a conservative way for these crypto traders to generate a recurring reward while guaranteeing they don't leave gains on the table.
Since it's a one-step options strategy for those with an already established long-only portfolio, covered calls become the most sensible move for crypto traders who believe that their portfolio holdings will moderately appreciate over the long haul. It's ultimately this simplicity and conservative approach that makes covered calls one of the most popular options strategies among crypto traders who are actively tracking market movements.
Benefits of using covered calls
Interested in the possible perks of writing covered calls for your crypto portfolio? Here are some of the advantages:
Unlike many existing options strategies, covered calls are easy to execute if you already own the underlying asset. It simply takes one step to write a contract against the cryptocurrency you're holding that states you'll be willing to sell the asset at a certain price if it exceeds the strike price by the contract's expiry.
You can earn premiums regularly by selling call options. While the frequency of these premiums depends on the crypto trader's activity in the market, writing these call options can be lucrative in the long run if you regularly sell calls with a margin of safety.
As previously mentioned, some crypto traders like to execute covered calls because they effectively act like a hedge against volatility and provide protection during sudden market downturns. This is because the premiums you receive from writing calls can be used to offset any losses on the underlying assets.
Risks of using covered calls
While covered calls offer hedging protection, they also have their own set of risks and disadvantages. Here are some worth noting:
Unfortunately, "if only I held longer" might be a common saying if you're a crypto trader who applies the covered call options strategy. That's because of the opportunities you'll potentially miss out on if the market abruptly rallies and rises above the strike price of your written call. That's why it's essential to carefully weigh upcoming catalysts and factors before implementing the covered call strategy.
Like all American options, those selling calls can be exposed to the risk of early assignment. This sometimes occurs when the price of the cryptocurrency exceeds the strike price and the call buyers choose to exercise their call early. This will force you to sell your held asset at the agreed price ahead of the contract's expiry.
How do covered calls work?
Now that we've explored what the covered call options strategy involves and why it's so popular among crypto HODLers, let's look at the execution aspect of a covered call. To better explain how covered calls work, we'll be using Bitcoin as an example and assuming you have a basic understanding of key factors like strike prices and option expiry dates. We'll also be using a Bitcoin reference price of $30,000 and the publishing date of this article for when the call contracts are written.
Suppose you own 1 BTC as part of your long portfolio and you decide to execute a covered call option. As a covered call beginner, you'd have to consider two aspects, namely the strike price of the call and the expiry date of the call. These two factors, along with various others, will impact the financial metrics that influence the price of options (also known as the 'Greeks') and determine the overall premiums you'll receive for writing the call option. Before diving into the mechanics of strike prices and expiry dates, here's a quick refresher on key terms.
Premiums: The amount you'll receive for selling the call option.
Strike prices: The agreed-upon price at which an option's underlying asset can be bought or sold when it's exercised.
Expiry date: The date by which the option must be exercised.
Determining your strike price
As a rule of thumb, the further out-of-the-money the strike price is from the current price of BTC, the cheaper the call option premiums will be. For the two instances below, let's go with the assumption that the call contracts being written have at least 30 days-to-expiry (DTE).
If you have a low risk appetite, covered calls are usually executed with a 30% margin of safety. This would equate to writing a call contract with a strike price of about $40,000.
Conversely, if you're willing to take on more risk at the cost of letting go of your BTC at a lower strike price, you can choose to execute a covered call strategy with a 15% margin of safety to receive more call premiums. This would translate to writing a call option with a strike price of about $35,000.
Deciding your expiry date
To better understand how expiry dates impact option premiums, one thing to note is that options with longer DTE are typically more expensive than short-dated options. For both examples listed below, let's assume that the calls being sold are at least 30% out of the money (OTM).
For more conservative and passive crypto traders, you may want to write contracts that have more than 30 DTE. Since they're more than a month out, there'll be more than enough time to repair the trade and roll your options if crypto prices don't move in your favor.
Do you actively keep up with the crypto market and want to take advantage of short-term volatility? You may want to consider writing contracts on a weekly basis instead. Call contracts with five or more DTE tend to be more volatile but allow you to speculate on the price of your underlying assets. If you aren't expecting much price movement from an upcoming news item, you can take the opposing end of the trade by writing a call.
Executing the covered call strategy for your crypto portfolio
From explaining strike prices to understanding expiry dates, it's now time to put everything together when executing the covered call for your Bitcoin holdings. Selling the $40,000 BTC call option with an expiry date of 24 November, 2023 will net you about $260 in premiums. This effectively means that you'll be selling your 1 BTC for $40,000 if it closes at that price at expiry. If the market rallies during this one-month period and BTC's price closes at $40,000, you'll be forced to sell your Bitcoin at this price and be credited with an additional $40,000 in your trading account.
If BTC's price fails to hit $40,000 by 24 November, 2023, you can keep your 1 BTC and the $160 call premium in gains. To keep the covered call strategy going, you may also proceed to write your next call contract and collect your next set of call premiums.
The covered call strategy stated above ultimately creates a form of income generation as you're regularly writing calls against the crypto position you're holding to earn option premiums while holding a long position in the market. While a sudden price spike might cause you to lose out on some gains, the call's strike price is ideally a price that you were comfortable letting go of your BTC at in the first place.
Final words and next steps
Covered calls are a versatile tool that can help you protect your portfolio holdings against the ever-changing world of cryptocurrencies. By combining the philosophy of HODLing with the strategy of selling covered calls, you can enjoy the benefits of both long-term potential and risk management. While variable factors like expiry dates and strike prices come into play, they're impacted by the crypto trader's risk appetite and how large of a risk they're willing to take on.
What if your covered call gets assigned and you lose your Bitcoin? The next sensible step would be to execute the cash-secured put options strategy, where you used the capital freed up from selling your underlying asset to buy the asset at a discounted price. Some veteran options traders call this combination of the covered call strategy and cash-secured put strategy the 'Wheel' strategy.