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What are Covered Calls?

PreviousWhy Rysk?NextBuilt by community

Last updated 1 month ago

Curious about the mechanics behind covered calls? This section is for you but here’s the best part: with Rysk, you don’t need to understand the intricacies of options trading to benefit from this strategy. Our mission is to make covered calls accessible to everyone, abstracting away the complexity so you can earn yield on your assets without being an options expert.

Understanding Covered Calls

Are you holding a long position and want to generate income? Covered calls are a great strategy. By selling call options against your existing holdings, you can earn premiums upfront while still benefiting from potential price increases.

A covered call is an undefined risk, neutral strategy, that combines a long underlying instrument position with selling a call option. Covered calls are most profitable when the underlying price increases slightly.

What sets covered calls apart from naked calls is that the seller holds the equivalent amount of the underlying asset while selling the call. This strategic move aims to generate a steady income stream from the portfolio.

How They Work

Covered calls provide sellers with an opportunity to earn extra income through the option premium while holding the underlying asset. They work best when minor movements (upward or downward) are anticipated in the underlying asset’s price.

Additionally, a covered call can serve as a short-term hedge for a long position. However, it’s important to note that sellers may forego potential gains if the underlying price surpasses the strike price.

While covered calls have a limited profit potential and do not eliminate downside risk entirely, they effectively mitigate the risk of the underlying instrument by the amount of the premium received. This can add an extra layer of protection for sellers.

Example

  • ETH Spot Price: $1,850

  • Strategy: Covered Call

  • Option: SELL ETH 30JUN23 $2000 CALL

  • Trade: Sell

  • Type: Call

  • Expiry: 30 June 2023

  • Strike: $2,000

  • Premium: $25

  • Underlying Instrument: BUY Spot ETH at $1,850

  • Breakeven: $1,825: Since ETH is bought at $1850 and strike price for the call option is $2000 the original position cost is reduced by $25 (premium received), making the cost basis and so the break even of the underlying position at $1825.

At expiry, on 30 June 2023, there are 3 possible payoffs:

  • ETH price is below $1,825: The call option will expire worthless and the trader can keep the premium but will also record a loss on the underlying. Therefore, by using the covered call, they outperformed holding the underlying instrument

  • ETH price is between $1,825 and $2,000: The call will expire worthless and the trader can keep the premium recording an overall profit equal to the spot price minus the breakeven

  • ETH price is above $2,000: The call will be exercised and the increase in ETH price is compensated by the loss of the call option. Therefore, the trader would have been better off holding ETH. The profit is capped at the strike price minus the breakeven. Although, if the trader planned to sell ETH at $2000 anyway, entering the call option gave an extra $25.

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