Bitcoin Covered Calls (Atomic Yield Series, Part 2)

In Part 2 of the Atomic Yield Series, we zoom in on bitcoin covered calls. We'll explain how they work, some potential strategies, and their tradeoffs.

a year ago   •   6 min read

By Craig Warmke

I. Introduction

With Atomic.Finance, you can earn yield on your bitcoin even though you keep both your private information and your private keys. In Part 1, we explained at a high level how the yield comes from covered calls and the privacy and self-sovereignty come from encoding them in discreet log contracts. We’ll save discreet log contracts for Part 3. Here, in Part 2, we zoom in on bitcoin covered calls. We'll explain how they work, some potential strategies, and their tradeoffs.

II. The ingredients of bitcoin covered calls

When you sell a bitcoin covered call, you own some bitcoin and sell its potential upside for a premium. With Atomic.Finance, selling your bitcoin's potential upside means that, in exchange for a premium, you agree to keep only the amount of bitcoin whose value equals a certain price (the strike) at some later date (the expiry). As a result, our covered call contracts are settled entirely in bitcoin.

For instance, suppose you have a single bitcoin currently valued at $40k. You then sell the following covered call:

The expiry is in 10 days.
The strike price is $60k.
The premium is .0011 BTC, or approximately 4% APY.

Then, in 10 days, one of two things happens depending on where the market or spot price of bitcoin lies.

The spot price is at or below the strike price.
In this case, you walk away with 1.0011 BTC — your original bitcoin plus the premium. This is the more likely outcome since bitcoin typically doesn’t shoot up $20k within ten days.

The spot price is above the strike price.
In this scenario, you keep the premium plus the fraction of your bitcoin that equals the ratio of the strike to the spot at expiry. To calculate this yourself, you can use the equation below:

(Strike Price / Spot Price on Expiry) × Amount of Bitcoin + Premium

Suppose the spot price on expiry is $80k — a drastic move to the upside. Plug the variables into the equation and you'll find that you get your premium plus the strike price of $60k worth of bitcoin. So you’re up in USD terms but down in bitcoin. You’re down .25 BTC to be exact because you sold the potential upside of your bitcoin beyond the strike price of $60k.

This second outcome illustrates the potential consequences of price risk, the risk of losing the upside beyond the strike price. But someone will pay you a guaranteed premium in bitcoin for the potential upside of your bitcoin. This premium is your yield.

Earning yield on your bitcoin always and everywhere comes at a price. You "pay" for yield by bearing risk, no matter whether the yield comes from bitcoin banks, exchanges, or from wrapping your bitcoin into WBTC and putting it on a network like Ethereum. In each case, some counterparty holds your private keys. So you bear counterparty risk — the risk of losing bitcoin due to hacks, insolvency, and so on. Since counterparty risk is obscure and difficult to calculate, it’s unclear whether the advertised yield fairly compensates you for bearing that risk.

Atomic.Finance does not custody your bitcoin. But there are still risks. The major risk you bear is the price risk unique to covered calls. But since you can calculate this risk, you can tell whether the premium on a covered call would fairly compensate you.

Overall, selling a covered call involves a trade-off. You trade potential upside for a guaranteed premium. But premiums change as market conditions change. So let’s look more closely at what determines the premium on a given call.

III. What Increases Risk and Yield?

Soon after you enter the Atomic.Finance app, you’ll see that each covered call has an annual percentage yield, or APY. These figures are annualized — if a ten-day call has 10% APY, then you’ll earn, in ten days, 10% divided by 36.5 (since ten days is 1/36.5th of a year). We annualize the yields not to mislead but to help you compare the yields of different length calls, apples-to-apples.

As you inspect the different calls more closely, you’ll soon notice two factors that affect the yield of a covered call.

The first is the duration between the present time and the expiry. The more time bitcoin has to reach the strike, the more likely it’ll reach it. So later expiries carry greater price risk. Hence, greater premiums accompany longer duration calls to compensate for that risk.

The second factor is moneyness, the difference between the spot price and the covered call’s strike price. The closer the current spot price is to the strike, the likelier that bitcoin will exceed the strike on expiry. Since smaller distances between spot and strike entail greater price risk, greater premiums accompany calls with lower strikes to compensate for that risk.

A third factor deserves special consideration. This third factor exerts a pull on the premium of all covered calls simultaneously, and so its effects are less obvious. This third factor is volatility, a measure on an asset’s price movements over time. Here is the basic rule:

big/quick price moves → greater volatility → higher premiums

This also makes sense: the higher an asset’s volatility, the likelier that an asset’s price will overshoot the strike. Selling covered calls in times of higher volatility carries greater price risk. So you’ll see higher premiums in times of higher volatility to compensate you for bearing heightened price risk.

Overall, greater premiums carry greater price risk. And the relative risk of each call owes to its duration and moneyness and bitcoin’s own volatility. With this in mind, let’s look at some possible strategies.

IV. Yield Strategies

There are four basic strategies for selling covered calls. Each has its own rationale and associated risks.

Strategy 1. Strike Price as Exit
You can transform price risk into an exit strategy. If you’ve already decided to sell some bitcoin at a certain price anyway, you can sell covered calls with that price as the strike price. Then, you earn yield until bitcoin reaches that price in the meantime. This effectively defangs the selling of covered calls.

Strategy 2. Grow Stack with Less Risky Covered Calls
Let’s say you don’t want to sell bitcoin but would willingly take small, calculated risks to earn a modest yield. In this case, you can sell covered calls with strike prices that bitcoin is unlikely to reach within a given time frame. You pocket your modest yield and more than likely keep your bitcoin.

Strategy 3. Sideways Bet
You want to accumulate more bitcoin but think the price will go sideways for some time. Then, instead of a highly conservative strike price, you may opt for a strike price closer to spot. You’ll earn a higher yield, but with higher yield comes greater price risk.

Strategy 4. Bearish Bet
As Stan Druckenmiller says, many bitcoiners behave like “religious zealots” and hold through severe drops. You might be such a zealot, happy to hold and accumulate more bitcoin even as the USD value goes down. So if you also have a bearish short term outlook, it can make sense to sell a high APY covered call with the thought that bitcoin’s price won’t be above the strike by expiry.

You can sell covered calls profitably in any market. But doing so always involves price risk. Whereas the first strategy transforms price risk into a beneficial exit strategy, the others involve a spectrum of risk vs. possible reward.

Unlike other leveraged bets, which risk total liquidation, no covered call will result in anyone losing their full bitcoin position. In the worst case, you walk away with the bitcoin valued at the strike price. And, furthermore, if you begin to think the price will move against you, you can hedge by buying a version of your covered call on another platform. Soon, we'll also have stop losses available to limit a contract's potential loss.

V. Conclusion

Here are some things to keep in mind.

  • Covered call contracts come and go, but lost bitcoin is forever. If you’re inexperienced with selling covered calls, practice first without risking real bitcoin. Then, when you’re ready, begin with small amounts.

  • Selling bitcoin covered calls may trigger taxable events depending on your jurisdiction. So you may want to consult a tax professional.

  • Our covered call contracts are settled entirely in bitcoin. Since these are encoded into discreet log contracts, you don’t need to give up your private information or your private keys.

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