The returns from decentralised finance are incredibly attractive, but option markets can also offer similar returns for those willing to take risks.
The number of investors interested in yield farming grew enormously over the past 6 months as decentralised finance (DeFi) applications became more popular and easier to use.
This has led us to see a countless number of liquidity pools offering an annual percentage yield (APY) in excess of 1,000% and how the total value locked in DeFi contracts increased to billions of dollars.
Bitcoin investors who wanted a piece of this huge pie were able to participate in DeFi’s yield farming by converting their BTC into tokenised versions such as Wrapped BTC (WBTC) and RenBTC (RENBTC).
This allows BTC holders to interact with all ERC-20-based tokens, but some analysts question how decentralised Bitcoin custody is behind these offerings; therefore, it makes sense to explore more centralised solutions.
Although it’s impossible to directly achieve the performance of Bitcoin deposits (BTC) on these DeFi platforms, investors can still benefit from centralised services. While it’s unlikely to find APYs above 12%, there are at least more secure ways to get a return with Bitcoin ‚uninvested‘.
Centralised services such as Bitfinex, Poloniex, BlockFi and Nexo will typically yield between 5% and 10% annually for BTC and stablecoins deposits. To increase the payout, it is necessary to look for more risk, which does not necessarily mean a lesser known exchange or intermediary.
By trading BTC options on the Chicago Mercantile Exchange (CME), Deribit or OKEx, an investor can comfortably achieve returns of 40% or more.
The hedged call strategy has its risks
The buyer of a call option can purchase Bitcoin at a fixed price at a set future date. For this privilege, this buyer pays in advance to the seller of the call option. Although the buyer can usually use this instrument as insurance, sellers primarily earn a fixed income from trading options.
Each contract has a predetermined expiry date and exercise price, so potential gains and losses can be calculated in advance. This so-called hedging strategy involves holding Bitcoin Bonanza Review and simultaneously selling the equivalent size in call options.
It would be unfair to call it „fixed income trading“ because potential losses are incurred whenever there is a more substantial price drop at the expiration of the options. However, this risk can be adjusted while the trade is being set up. It is worth noting that limiting exposure will result in lower returns.
The chart above represents a hedged call strategy for next November’s maturity, with a yield of 6% profit in two months, equivalent to an APY of 41%. As mentioned above, the hedged call strategy may incur losses if the BTC price at maturity is lower than the strategy’s threshold level.
Although the 6% return is achieved by selling call options from 0.5 BTC to USD 9,000 and 0.5 BTC to 10,000, the strategy requires BTC to remain above USD 10,000 at maturity on 27 November to achieve that profit margin. Any level below USD 8,960 will result in a loss, but that’s 16.6% below the current Bitcoin price of USD 10,750.
By selling these call options, investors will get 0.1665 BTC (USD 1.957 at today’s price); therefore, the covered call investor must purchase the remaining 0.8335 BTC (USD 9.793) through the regular futures spot markets. However, if the buyer is unwilling to take this risk, it is possible to lower the loss threshold.
It is worth noting that most derivatives exchanges allow exchanges of options starting from BTC 0.10, with the only exception being CME.
An APY of 25% can be achieved by selling November call options from 0.5 BTC to USD 8,000 and 0.5 BTC to USD 9,000. By reducing expected profits, you will only face negative results below USD 8,370 for the 27 November maturity, 22% below the current spot price.
Note how the net gain of USD 313 stabilises above the USD 9,000 result. To achieve this balance you need to buy USD 8,187 worth of BTCs either through futures or regular spot markets. The call option premium will increase the remaining 0.303 BTC (USD 3,257), but only the seller of the option is paid in advance.
Implied volatility drives gains in covered calls
Implied volatility is the main indicator of risk in the options markets and it increases as traders perceive a greater risk of sudden price movements. This indicator will increase regardless of investor optimism, as volatility is based solely on absolute price changes.
A constant daily loss of 4% over a few weeks results in extremely low volatility, which would be the same as a fixed daily gain of 4%. Volatility will increase in periods of extreme uncertainty; therefore option sellers will demand a higher premium.
As Skew’s data shows, the implied volatility of 3-month BTC options is currently 59% annualised. Although relatively low, this is still sufficient to provide an APY of 41% using a covered call strategy.
Investors may benefit from higher expectations, but the risk of loss using hedged calls also increases. This reflects traders‘ fears of unexpected price swings; therefore, higher implied volatility indicates a greater likelihood of a maturity price below the profit threshold of the option strategies.
All investments have some degree of risk
All passive return strategies have built-in risks. While it is possible to use a stop loss on a strategy called hedged, it should be noted that the options markets can be reasonably illiquid during sharp swings in BTC prices. This means that it is important here never to close out spot futures or positions independently of options.
DeFi can have its appeal, and even if one is willing to accept the risks associated with BTC wrapping, there are questions about faulty smart contracts, possible DeFi protocol violations, stagnation in the Ethereum network during peak traffic times and rising commissions which can reduce profits and increase losses. Outside of individual pools and DeFi applications, there is also room for manipulation of an oracle’s price source, which can cause cascading settlements.
The main advantage of the call cover strategy is that it allows investors to establish their own appetite for risk and have a clearer picture of their potential gains.
By opting for centralised solutions, investors can avoid high gas fees and the risk of being overtaken by the richer or more knowledgeable DeFi farmers.