What is crypto options trading?
A crypto options contract grants the holder the right, but not the obligation, to purchase (call option) or sell (put option) an underlying cryptocurrency at a predetermined price (the strike price) on or before a specified date (the expiration date).
Instead of holding the actual asset, traders bet on the fluctuations in value of the underlying cryptocurrency. If investors believe prices will rise, they will buy calls; if they believe prices will fall, they will buy puts.
This approach restricts possible losses to the option price paid while enabling profit from both rising and declining markets. Option pricing is influenced by variables such as volatility, time to expiration and the price of the underlying asset. Nevertheless, options trading may be complex and risky, necessitating a thorough comprehension of risk management techniques and market dynamics.
Covered call option and its purpose, explained
In options trading, a covered call option strategy is a well-known tactic where an investor simultaneously sells a call option on the underlying asset — such as a cryptocurrency — while still owning the underlying asset.
The purpose of this technique is to profit from any increase in the underlying asset’s price as well as from the premiums obtained from selling the call option. The two main parts of the covered call strategy’s mechanism are selling a call option and holding the underlying asset.
Initially, the trader’s portfolio holds a specific quantity of the cryptocurrency in their portfolio, which ensures their capability to fulfill the obligation should the option be exercised. Subsequently, the trader sells a call option, which grants the buyer the right to buy cryptocurrencies within a given time frame (up to the expiration date) at a predetermined price (the strike price).
The trader gains an upfront premium by selling the call option. The option will probably expire worthless, and the trader will keep the premium as a profit if the price of the cryptocurrency stays below the strike price until it expires. The option could be exercised, requiring the trader to sell the cryptocurrency at the agreed-upon price if the price climbs above the strike price. The trader’s potential gains from the underlying asset are capped at the strike price, even though they still benefit from the premium they received.
Crypto-covered call vs. uncovered call
The trader’s level of risk and obligation is the main difference between an uncovered call and a covered call in the cryptocurrency space.
Since the trader already owns the underlying cryptocurrency in a covered call strategy, they are protected from future losses. The trader can profit from the premium they earn by selling a call option on that cryptocurrency; however, their risk is lower because they can deliver the asset in the event that the option is exercised. Because it restricts possible gains and depends on asset ownership to offset potential losses, this strategy is regarded as relatively cautious.
On the other hand, selling a call option on a cryptocurrency without holding the underlying asset is known as an uncovered call, or naked call. Using this approach, if the cryptocurrency’s price increases far above the strike price, the trader is exposed to an infinite risk.
Should the option be exercised, the trader’s commitment to buy the cryptocurrency at the market price would have to be met, which might lead to significant losses. Uncovered calls are riskier and more speculative because traders don’t hold any assets to offset losses; instead, they rely only on market movements for profit.
Step-by-step process of implementing a covered call in crypto
In cryptocurrency, a covered call technique can be implemented when a trader owns a sufficient amount of the underlying cryptocurrency and then sells a call option on that asset with a strike price and expiration date that suits their strategy.
The trader begins by deciding which cryptocurrency they are prepared to sell at a fixed price. Then, they evaluate the state of the market, taking into account the volatility and general price trend of the cryptocurrencies.
Next, taking into account variables like strike price and expiration date, the trader chooses which call option to sell. Moreover, traders choose a strike price above the current market rate but low enough that they’d be comfortable selling the asset if the option is exercised.
Upon deciding on the call option, the trader uses their preferred trading platform to execute a sell-to-open order, essentially selling the call option to a different investor in return for the upfront premium. By taking this action, the trader agrees to the possibility of selling their cryptocurrency at the strike price in the event that the option is exercised.
The trader keeps an eye on market moves during the option’s duration and decides whether to buy back the call option to end their position or let it expire. The trader keeps the premium as profit if the option expires worthless or is bought back at a lesser price. If the cryptocurrency’s price rises and the option is exercised, they’ll profit by selling at the strike price, which is higher than when they began the covered call.
Let’s take an example to understand the above process. Suppose a trader owns 100 Ether (ETH), purchased at $1,600 each. At the current market price of $1,700, the trader expects modest to moderate price movement upward. They sell a call option with a $1,800 strike price that expires in a month for a premium of $5,000. If ETH stays below $1,800, the option loses all of its value at expiration, and the trader keeps the premium. The option buyer may exercise their right and compel the trader to sell at $1,800 if ETH increases sharply. The trader loses out on additional gains above the strike price, but they still benefit from the premium and price growth.
Strategies to manage covered calls in crypto
To maximize profits and reduce risks, managing covered calls in cryptocurrency requires monitoring the state of the market and the underlying cryptocurrency’s performance on a regular basis.
Traders may decide to purchase back the call option at a loss if the price of the cryptocurrency rises sufficiently to avoid perhaps selling their asset below market value. On the other hand, traders may let the option expire worthless to keep the premium they will earn when the price drops or stays reasonably stable.
Buying back the existing call option and simultaneously selling a new call option with a later expiration date or a higher strike price is another tactic for rolling over a covered call position. This enables traders to keep earning money from premiums and even profit from changes in the underlying asset’s price in the future.
Furthermore, to limit potential losses, traders can use stop-loss orders to automatically cancel their covered call position if the price of the cryptocurrency reaches a predefined threshold. That said, risk management strategies catered to specific trading goals and market circumstances are necessary for the efficient administration of covered calls in the cryptocurrency space.
Covered call benefits for crypto investors
Covered calls offer investors a way to generate income, enhance returns in certain market conditions, and mitigate risk by collecting premiums in exchange for the possibility of selling their cryptocurrency at a predetermined price.
Investors can increase their investment returns by selling call options on their assets and earning premiums upfront. This source of income, which offers a consistent supply of cash regardless of price movements, might attract traders who want to stay profitable in the volatile cryptocurrency market.
In sideways or slightly bullish markets, covered calls may help investors increase their gains by collecting option premiums on top of any potential price appreciation of their cryptocurrency holdings.
Moreover, by acting as a safety net against any losses, covered calls assist investors in risk management. The average cost basis of the underlying cryptocurrency is essentially decreased by the premiums obtained from selling call options. As a result, even in the event that the asset’s price drops, downside protection can be maintained since the income from premiums can partially offset losses.
Risks of covered call strategy in crypto
Covered calls have inherent risks despite their potential benefits, particularly given the unstable and quickly evolving nature of the crypto market.
Selling call options carries a substantial risk, including the possible opportunity cost. If the price of the underlying cryptocurrency rises over the strike price, the trader may lose out on huge gains because they are required to sell the asset at a fixed price.
Additionally, there’s a chance that possible upside gains will be limited. Traders may not be able to fully benefit from notable gains in the price of the underlying cryptocurrency because covered calls cap the possible profit at the strike price plus the premium received.
Covered call writers (the sellers of the option) also run the risk of getting assigned. The option buyer may exercise their right to purchase the asset if the price of the cryptocurrency climbs over the strike price. This would compel the covered call writer to sell at the agreed-upon price, limiting their profit potential if the asset’s value continues to rise. This is called being “assigned.”
Additionally, in volatile markets, the premiums earned from selling call options could not be sufficient to cover possible losses in the event that the underlying cryptocurrency’s price falls sharply. Ultimately, investors should carefully consider the risks associated with using covered calls versus the possible rewards when employing this technique in the cryptocurrency market.