TLDR
Earn yield on the underlying collateral in "trending down", sideways or bull markets
The vault sells out-of-the-money (OTM) put options to generate the yield.
It simultaneously buys further OTM put options to limit downside risk in case of a large price drop.
How does the Covered Put Spread Strategy work?
A covered put spread is a trading strategy that involves holding the underlying asset as collateral while selling put spreads against it.
The automated Covered Put Spread Strategy consist of three main components:
Deposit the underlying asset as collateral into the vault.
Each week, the Vault will:
A. Sell OTM put options against it to earn yield; and
B. Buy further OTM put options to limit the downside risk in case of a large price drop.
After expiry, the Vault will either:
A. Buy collateral - If option settlement results in a positive USDC balance.
B. Sell collateral - If option settlement results in a negative USDC balance.
For a technical overview of how the Vault executes, please refer to the Covered Put Spread Execution article.
Why participate in the Covered Put Spread Strategy
The primary benefit of the Covered Put Spread Strategy is earning yield on the underlying asset by selling OTM put options (Strike K1).
To limit the downside risk, the strategy trades off a portion of the yield APY by also buying further OTM put options (Strike K2).
In the event the price drops significantly, the
max capped USDC loss = max(Strike K1 - Strike K2 - net premium received, 0).The strategy is best suited for holders of the underlying collateral who want to earn yield on their asset in a mildly bearish to very bullish market, while limiting the downside risk in case of a large price drop.
What are the risks of the Covered Put Spread Strategy?
The main risk of the Covered Put Spread Strategy is collateral conversion.
If the sold put spread expires ITM and the net premium received is not enough to cover the settlement loss, the Vault sells collateral to clear the USDC debt.
However, as mentioned before the max loss is capped in USDC terms (as described above)
For the implementation risks, please refer to Covered Put Spread Risks.
Example
Let's take LBTC as an example:
BTC price: $60,000
Collateral in the Vault: 100 LBTC, worth $6,000,000
The Vault sells 100 BTC put options with a $56,000 strike for $250 each and buys 100 BTC put options with a $54,000 strike price for $100 each.
Net premium received: $15,000.
Scenario 1: BTC expires at $60,000
Both the short put options ($56,000 strike) and the long put options ($54,000 strike) expire OTM.
Breakdown:
Net Premium: +$15,000.
Short Put Options: $0 (expired OTM, worthless).
Long Put Options: $0 (expired OTM, worthless).
Total: +$15,000.
—> Vault buys 0.25 LBTC with the $15,000 to compound the yield.
—> Vault is up 0.25% in LBTC terms
Scneario 2: BTC expires at $55,900
The short put options ($56,000 strike) expire ITM and the long put options ($54,000 strike) expire OTM.
Breakdown:
Net Premium: +$15,000.
Short Put Options: -$10,000 ($55,900 - $56,000 * 100).
Long Put Options: $0 (expired OTM, worthless).
Total: +$5,000.
—> Vault buys 0.09 LBTC with the $5,000 to compound the yield.
—> Vault is up 0.09% in LBTC terms
Scenario 3: BTC expires at $55,500
The short put options ($56,000 strike) expire ITM and the long put options ($54,000 strike) expire OTM.
Breakdown:
Net Premium: +$15,000.
Short Put Options: -$50,000 ($55,500 - $56,000 * 100).
Long Put Options: $0 (expired OTM, worthless).
Total: -$35,000.
—> Vault sells 0.63 LBTC to clear the $35,000 debt.
—> Vault is down 0.63% in LBTC terms
Scenario 4: BTC expires at $52,000
Both the short put options ($56,000 strike) and the long put options ($54,000 strike) expire ITM.
Breakdown:
Net Premium: +$15,000.
Short Put Options: -$400,000 ($52,000 - $56,000 * 100).
Long Put Options: +$200,000 ($54,000 - $52,000 * 100).
Total: -$185,000 (note, the max USDC loss is always capped at $200,000).
—> Vault sells 3.56 LBTC to clear the $185,000 debt.
—> Vault is down 3.56% in LBTC terms