TLDR
Covered Call Tokens allow users to participate in a Covered Call options strategy.
The Covered Call strategy effectively allows holders of the underlying asset to commit to a limit sell order, at a higher price, for a period of time (via selling call options), in return for yield on their asset.
The key risk to selling covered calls is that asset holders miss out on price appreciation of their asset, beyond the strike price of the option.
Covered Call writing is best suited for neutral-to-bullish market conditions. On the upside, profit potential is limited, and on the downside there is the full risk of holding the asset below the strike.
What is a covered call?
A covered call is a simple trading strategy with two components:
An asset that you own
A short call option on the same or similar asset, using the asset itself as collateral
In return, covered call sellers receive yield via USDC premiums.
A call option has two key dimensions to consider for covered call execution:
Its strike: the price which the option buyer can purchase the asset from you
Its expiration: the date on which the option buyer can buy the asset, for the strike price
Changing these parameters affects the yield generated by the option.
Higher strike = lower yield (you are committing to selling the asset at a higher, or worse, price)
Shorter expiry = lower yield* (you are committing to selling the asset for a shorter period, which is less optionality and value for the buyer)
*However if you ‘roll’ the strategy by executing weekly, the yields are generally higher (with higher risk) for shorter dated rolling strategies.
Why would I sell covered calls?
Selling covered calls boils down to pre-committing to limit sell orders, and getting paid for it. In return, you sacrifice upside if the price of the asset you’re trading rapidly increases. The annualized yield afforded by selling covered calls typically ranges from 10-50% on the collateral posted.
Covered calls are generally best for:
Medium to large size holders of the underlying asset
Interested in generating cash flows
Who are targeting a sell price that is above the current price
The downside of the strategy is two-fold:
You stand to miss out on upside if the price goes up, quickly
You remain exposed to the downside if the asset loses value
Derive Covered Call Tokens are designed to:
Sell weekly upside calls (with a roughly 10-15% chance of expiring in the money)
Collateralized with the same or similar asset
It is important users consult the up-to-date information on yield and points programs in the app before entering a strategy, as these are subject to change.
Example
Alan sells 100 covered calls using rswETH as collateral.
ETH is trading at $3,000
Alan has 100 rswETH (Swell’s native restaking token), worth $300,000
Alan deposits 100 rsWETH into Lyra’s tokenized strategy, and mints Restaked Swell ETH Covered Call tokens (rswETHC)
The Covered Call Strategy executes a trade which sells 100 ETH $3,500 calls for $10 each, expiring in 7 days
There are two possible scenarios where the outcome differs between selling covered calls and simply holding the underlying asset.
Scenario 1
ETH finishes the 7 day period at $3,400.
When ETH finishes at or below $3,500, Alan earns more than he would have had he not used the strategy.
Earnings breakdown:
100% of the principal (100 rswETH)
$1,000 in premium income ($50,000 / year = 20% annualized)
$60 in staked ETH yield ($3,000 / year = 3% annualized)
EigenLayer points, boosted Swell points and DRV points (30 points per hour per ETH; uncapped deposit limit)
Scenario 2
ETH finishes the 7 day period at $3,600.
In this case, Alan's P&L is positive, although less positive than if he had just held rswETH and not used the strategy.
Earnings breakdown:
97.22 rswETH (100 rswETH principal - 2.78 rswETH to pay out the options that expired in the money)
$1,000 in premium income ($50,000 / year = 20% annualized)
$60 in staked ETH yield ($3,000 / year = 3% annualized)
EigenLayer points, boosted Swell points and DRV points (30 points per hour per ETH; uncapped deposit limit)
The options Alan sold are in the money, so he needs to pay out by selling some rsWETH (at $3,600) and paying back the $10,000. In this case, Alan would need to sell $10,000/$3,600 = 2.78 swETH, and he would be left with 97.22 swETH plus the yield he earned.
Strategy Risk
This is the drawback of selling options. You can end up selling cheap if the asset price rallies quickly (in the case of Scenario 2 above, ETH rallied 20% in a week).
But even if that happens and you lose on the options trade, it’s not necessarily a net loss. In scenario 2, Alan's P&L across his portfolio is positive. That’s because his rswETH holdings increased in value from $300,000 to $360,000 (+$60,000). Those profits dampen the loss from paying off the options obligations. When you add the premiums and yield, this more than makes up for the loss. But that is the risk of the strategy. You may miss out on some upside in return for income and yield.
Conclusion
Derive vaults are aimed at existing holders of the underlying asset. However, if you decide to purchase the underlying asset to mint Covered Call Tokens, please be aware of the extra risks involved (detailed here).
Derive's Covered Call Tokens allow users to execute the covered call strategy with the underlying asset as collateral. Covered calls are a powerful and sustainable strategy for traders and investors who want to generate yield on their assets through options selling. In return for giving up potential upside in their asset, they receive yield.
Traders should understand the strategy and weigh up the risk/reward profile before participating.