The Purpose Bitcoin Yield ETF and Purpose Ether Yield ETF aim to harness the volatility of the cryptocurrency markets to help investors earn long-term yield by using a covered call strategy. This article outlines how a covered call strategy works in the crypto context and provides a basic overview of what call and put options are and the benefits and risks of covered call strategies.
Options are financial contracts that provide the option buyer with the right to buy or sell an asset at a predetermined price by a predetermined date. The seller (or writer) of the option, however, is obligated to either buy or sell the underlying asset should the buyer decide to exercise the option. Exercising an option simply means that the buyer uses their right to sell or buy the asset at the originally agreed upon price. To obtain this right, the buyer of the option pays a premium to the seller. The seller keeps the premium regardless of whether the option is exercised or not.
There are two main types of options: call and put options.
Call options give the buyer the right to buy an asset, while put options provide the right to sell an asset at a predetermined price. This predetermined price is called the “strike price.” Whether the right gets exercised or not depends on the relative positions of the asset price and the strike price. For call options, the option can be exercised if the asset price is above the strike price, which makes economic sense.
For put options, it’s the opposite: the asset price has to fall below the strike price for the option to be exercised. Whether the option is worth anything, or makes economic sense to exercise, can be summarized with the term “moneyness.”
For example, a call option where the asset price is lower than the strike price is referred as “out of the money.” This gets the point across that the asset price isn’t high enough to justify exercising the option. When the asset price equals the strike price, the option is “at the money,” and when the asset price is above the strike price, the option is “in the money.” For put options, the opposite is true.
From the perspective of buyers, options can be thought of as leveraged products, providing exposure to an asset by simply paying a premium that is far less than the price of the asset itself. This makes options a useful tool for speculative trades. Conversely, options can also be used to hedge and limit downside exposure to protect a portfolio. From a writer’s perspective, options can be a steady source of income—if structured properly—from an asset by selling a right for the counterparty to buy or sell the asset.
This is where Purpose Bitcoin Yield ETF and Purpose Ether Yield ETF come into play. Both funds are structured to sell (write) options on bitcoin and ether to generate a steady source of income, while being long on the cryptocurrencies. This strategy is also referred to as a covered call. We go into detail below.
A covered call is an options’ strategy where the seller of the call option owns an equal amount of the underlying asset. The writer of the option holds a long position on the underlying asset and sells the right for someone else to buy it at a given price, typically slightly higher than the current price of the asset.1 This strategy is commonly used by investors who want to hold an asset for the long term, do not expect a significant price appreciation in the near term, and want to generate income or have a slightly defensive posture in the short term. The chart below illustrates the difference between simply holding an asset versus selling a call option on it.
Considering an asset priced at $8 and a call option with a strike price of $10: if the asset loses value, the covered call will always outperform the long exposure by the premium amount. This also works if the asset appreciates but stays below the strike price. However, at any point beyond the strike price, a covered call will stop participating in price movement, and therefore the performance outcome will tilt towards holding the asset long term.
In essence, the covered call writer is selling the price participation beyond a certain level in the asset that they hold. While the seller generates income from price participation, limited to the difference between the strike price and the initial asset price ($2 in this example), the main source of income is the premium.
Premiums are affected by a variety of factors such the moneyness, time to maturity, and the volatility of the underlying asset. The higher these factors are, the higher options premiums tend to be. Here we focus on the volatility aspect simply because it is inherent to the asset itself and not within the control of the writer of the option.
In relation to the options market, volatility refers the market-price fluctuation of the underlying asset. We can differentiate volatility into two different classes:
1) Historical Volatility: The observed price fluctuations over the course of a given period.
2) Implied Volatility: What the market expects the price movements of a given stock to be for the upcoming period.
The above example shows how volatility can explain the path of a given stock and illustrate how something can be volatile even if the price at the beginning and end of a time period are generally the same. Although both stocks start and end at $100, their journeys are quite different.
The stock that has a wider band will have a higher chance at reaching the strike price compared with the one that has a smaller band. As a result, in general, the higher the volatility of a stock, the higher its premiums will be. Simply put, the seller of the option will be compensated for the additional probability of the option being exercised.
Premiums are unique in this aspect, giving investors the ability to monetize volatility. This results in additional income with added diversification benefits. In addition, premiums are usually taxed as capital gains as opposed to income, which is the case for interest income (e.g., fixed income).2,3 Both of these factors make premiums an attractive source of income.
What Does the Payout Look Like?
Not all covered call strategies are created equal or have the same payout structure. When considering covered calls as a part of a portfolio, we must consider how much of the underlying assets are used for the covered call strategy.
For example, a covered call strategy using 25% of the assets while being long on the rest (75%) will perform differently compared with one that has call options covering 50% or 75% of the assets. As long as the prices remain below the strike price, the strategy with a higher percentage of covered calls will outperform those with lower because of the higher premiums. However, if prices increase above the strike price, the portfolio with higher long exposure (less percentage covered) will have a higher price participation or performance.
In addition to how each covered call strategy performs relative to one another, covered call strategies, in general, behave differently in different market environments. In a bear market, the premiums offered by options create a buffer and limit negative price movement. In a sideways market – similar to a bear market – the premiums create an additional source of income, allowing the portfolio to outperform the market. However, in a bull market, strong price appreciation means calls get exercised, which causes the portfolio to have capped price participation on the covered portion of the portfolio, in addition to premiums.
Connecting Covered Calls and Crypto
Now that we have all of that in the bag, let’s talk about how this translates into the cryptocurrency world. As we previously mentioned, volatility means a higher likelihood of hitting the strike price—as a result, call writers require higher premiums to offset that risk.
Furthermore, when we think of cryptocurrencies, what is the first thing that comes to mind? Sure, “to the moon,” but what comes after that? Once we go beyond all the memes, it is the volatility that stands out.
The price movements that make the biggest stock market crashes look like small bumps are becoming synonymous with cryptocurrencies. Below is the daily volatility of Bitcoin, Ether, and the S&P 500 over the past five years. As illustrated below, there’s a significant difference between the crypto world and traditional assets in terms of volatility.
Since the price of Bitcoin and Ether are often volatile, crypto premiums should be more expensive than traditional assets. One way to look at this is to compare the 10% out-of-the-money call option for Bitcoin or Ether with that of the S&P 500.
While SPY has a $0.09 premium for a ~10% out-of-the-money call option, ETHH has a $1.25 premium, which is more than 10 times that of the S&P500.4 It is clear that the volatility of cryptocurrencies can translate into option premiums, creating a significant source of income.
Covered call options enable investors to generate additional short-term income on an asset they believe in for the long term. This strategy can limit the downside during bear markets and provide a source of income when prices are flat. Furthermore, it can elevate returns in markets with slight price appreciation, but will underperform once prices reach high enough to limit price participation.
Given the connection between the volatility of the underlying asset and premiums, covered call strategies on cryptocurrencies offer unique exposure to a unique asset class, providing investors a high yield without sacrificing significant price participation.
- 2) https://www.taxtips.ca/personaltax/investing/taxtreatment/options.htm
- 3) https://equitable.com/products/investment-strategies/questions/taxes-on-investment-income
- 4) Bloomberg, as of December 13, 2021. ETHH.B as a proxy for Ether; SPY as a proxy for S&P500. All prices in USD.
All data sourced to Bloomberg unless otherwise noted.
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