What Is A Covered Call: How to Lower Risk in Bitcoin Leverage Trading

Summary:

• “Calls” are bullish options that predict price appreciation and “puts” are bearish options that predict price depreciation.
• A covered call is known as a “buy-write.” It is a trading mechanism in which the owner of crypto such as Bitcoin purchases options in the opposite direction of their trade – i.e. they short Bitcoin but they buy long calls that the price will go up.
• While the position is de-risked, this also limits the trader’s upside potential because they are hedging in both directions.

Options traders invest capital on call and put options based on the spot price. Their position is at risk because the options can expire worthless if they don’t make the right trade.

What happens if an options trader opens a long position on an asset like Bitcoin (BTC) but the price ends up stagnating and there’s little price action?

To de-risk, they employ a hedging strategy that allows them to play both sides of the trade. If the trader is shorting Bitcoin, but purchases bullish long calls, they can cover their position.

Covered calls, or “buy writes”, are a popular hedging technique that allows Bitcoin owners and options traders to increase their safety while leverage trading.

An options call assumes the price will appreciate; therefore covered calls are bullish in nature. In the event the short goes wrong, the trader can sell their calls and cover their short position.

What Is A Covered Call?

A covered call hedges against the risk of loss (Source: Accessible Investor)

A covered call is a two-sided hedging strategy in which the owner of a crypto purchases option calls against their position.

The term “covered call” can be understood as a long option (call) and a cover position for an existing position.

For comparison, a “naked call” is a call in which we don’t have a second position and we’re only betting on the chance the asset goes in that direction.

A covered call strategy for shorting Bitcoin is used when we want to cover that position in case it goes up. In this case, we can purchase long calls that expect the price to appreciate. Covering our calls significantly reduces our risk of losing capital.

The standard amount traders purchase in the stock markets is 1 call for every 100 shares of stock. To apply that to the crypto markets, we could split 1 option call for every 0.001 BTC – or 1/100th of a Bitcoin.

Despite a covered call being a market-neutral strategy, it leans more on the bearish end. A covered call implies we’re shorting in our main position, and it is very risky to do in crypto. This is because the bearish cycles are not as long as they are in the stock markets.

When Do We Need A Covered Call?

A covered call is used in sideways and unpredictable/non-trending markets. A covered call option will help if we don’t know where the price of Bitcoin might be a week or a month from the trade.

If we’re in a bull market and Bitcoin is making all-time highs every day, we know that the trend points upwards and we can open a long naked position without covering on the other end. As we don’t have to spend extra to de-risk, our profit potential is maximized.

Likewise, if we’re shorting Bitcoin during a bear market, we don’t need a covered call. This is because the price will likely trend downwards until it reaches historic support levels at half the cycle peak.

Say we opened a short on Bitcoin at $30,000 in May 2022 and decided to cover our short with a long option call. The long would cover our short if Bitcoin shot up to $40,000, but it continued on its downward trajectory to $20,000 and below; effectively rendering our cover useless.

A covered call strategy can be useful for day-trading when there isn’t significant price action and we want to safely trade without being surprised by significant price swings.

In the traditional markets (i.e. stocks) traders buy covered calls to sell at a later date for passive income. This is not yet possible in the crypto markets as most trading platforms don’t offer call and put options.

How Do Covered Calls Work?

Covered calls are options tied to a spot asset; therefore we need to purchase option calls to cover our position.

Note: A trader can also create covered puts by purchasing put covers for their long spot position.

As with any other options, we have an expiry date that is specified by the DTE (days to expiration). The profitability of the covered call will vary by the spot price of the asset for the duration of the call.

The expiry date affects the premium price because a longer expiry date has a higher chance of ending up a profit and the trader selling it then. A shorter expiry call will have a lower premium price to purchase.

The trader also has to set a “strike price” which matters for moneyness (ITM, OTM, ATM). If the spot price reaches the strike price on the option, the option can expire ITM (in-the-money) and provide them a profit.

Effectively, the expiry date and the strike price are the two most important considerations for a trader.

Example of A Covered Call

Let’s take a Bitcoin covered call option as an example. At the time of writing, Bitcoin is trading at $18,000. If a trader wants to short Bitcoin from this point on, they’ll have to purchase call options to cover their trade. These covered calls options specify a strike price and an expiry date.

While their short trade is ongoing on the spot market, they can purchase long call options with a strike price of $20,000 that bet the price of Bitcoin will surpass $20,000 in the current month. They now have a long call option in case their short trade goes wrong which they can sell ITM.

If the trade reverses and Bitcoin goes up above $20,000, the trader is now in profit despite losing on their short trade (which can be closed out).

What Happens When A Covered Call Expires In The Money?

If the covered call expires ITM, the trader can exercise their call option and receive a profit in addition to their premium. Let’s say they paid a $1,000 premium for the option. In that case, they would receive their $1,000 back plus the profit on the difference between the strike price and the spot price.

On the other hand, if the covered call doesn’t expire in the money, it will expire worthless. This means that the trader will get their $1,000 premium back and retain their existing short position.

However, if the spot price of Bitcoin is below the covered call strike price, then the trader would not receive their initial $1,000 premium back. That option would generate a loss while their main trade is in the green.

How to Sell Covered Calls?

A trader can sell their covered calls before the expiry date or after the expiry date if they’re ITM on the platform.

The most common time for traders to sell their options is when the value of that option surpasses the initial premium paid. If a trader is in profit and they’ve doubled or tripled their investment, they can sell their option before it expires.

Their breakeven price is the price of the premium paid. This is the minimum they need to stay afloat, but with a balanced act of trading in the opposite direction, the trader will likely be above water in all cases.

Are Covered Calls Risky?

Not really. The risk is low because we are hedging from both ends of the trade. The only risk is being over-leveraged on one side of the trade – i.e. we pay a higher premium on the options call than our initial spot position is worth.

In that case, it may be hard to break even in the event the over-leveraged trade goes wrong.

This safety cushion can actually be considered a downside of covered calls. If we’re covering our spot position on Bitcoin with puts or calls, we might miss out on monumental rises or falls in the meantime. This is because we’re allocating half of our capital on the other trade.

Bitcoin is known to make 100%+ moves in a matter of days, and if we’re long on Bitcoin, the covered put would make us lose out on realizing gains to the fullest potential.

Conclusion

Covered calls are a market-neutral strategy. This technique is mostly used in the stock and forex markets for leverage trading and can be implemented in the crypto markets.

If we’re holding crypto, we generally assume it’s going to appreciate in price over the long term. However, in the short term, this might not be the case and we can make a profit on the downturns.

In the event our trade goes wrong, we use the covered calls strategy to purchase options on the other spectrum of the trade and profit regardless of the direction of the spot price.

Traders also have the ability to hold on to the calls for a longer time and generate income from the premiums.