The number of investors interested in yield farming has grown immensely over the past 6-months as decentralized finance (DeFi) applications became better known and easier to use.
This has led to an uncountable number of liquidity pools offering annual percentage yields (APY) surpassing 1,000% and the total value locked in DeFi contracts has risen to billions of dollars.
Bitcoin investors who wanted a piece of the action managed to participate in DeFi yield farming by converting their BTC into tokenized formats like Wrapped BTC (WBTC) and renBTC (RENBTC).
This allows BTC holders to interact with all of the ERC-20-based tokens, but some analysts question how decentralized the Bitcoin custody is behind those offerings; therefore, it makes sense to explore more centralized solutions.
Although it is impossible to directly extract yield on Bitcoin (BTC) deposits at these DeFi platforms, investors can still benefit from centralized services. While it is improbable to find APYs above 12% there are at least safer ways to earn yield on ‘uninvested’ Bitcoin.
Centralized services such as Bitfinex, Poloniex, BlockFi, and Nexo will typically yield 5% to 10% per year for BTC and stablecoin deposits. To increase payout, one needs to seek higher risk, which does not necessarily mean a less known exchange or intermediary.
By trading BTC options at Chicago Mercantile Exchange (CME), Deribit, or OKEx, an investor can comfortably achieve 40% or higher yields.
The covered call strategy has its risks
The buyer of a call option can acquire Bitcoin for a fixed price on a set future date. For that privilege, this buyer pays an upfront for the call option seller. Although the buyer might typically use this instrument as an insurance, sellers are mostly obtaining fixed income trades.
Each contract has a predetermined maturity date and strike price, so potential gains and losses can be calculated beforehand. This covered call strategy consists of simultaneously holding BTC and selling the equivalent size in call options.
It would be unfair to name it a fixed income trade, as potential losses loom whenever there is a more considerable price drop at options expiry. However, one can adjust such risk while setting up the trade. It is worth noting that limiting exposure will result in lower yields.
Expected returns for a November $9.5K covered call. Source: Deribit
The above chart represents a covered call strategy for the November expiry, yielding a 6% return in two months, equivalent to 41% APY. As previously mentioned, the covered call might present losses if the BTC price at expiry is lower than the strategy threshold level.
Although the 6% yield achieved by selling 0.5 BTC at $9K and 0.5 BTC $10K call options, the strategy needs BTC to sustain above $10K at the November 27 expiry to achieve its full return. Any level below $8,960 will result in a loss, but that is 16.6% below the current $10,750 Bitcoin price.
By selling these call options, the investors will make 0.1665 BTC ($1,957 at current price); therefore, the covered call investor should acquire the remaining 0.8335 BTC ($9,793) either via futures regular spot markets. However, if the buyer is unwilling to take this risk, it is possible to reduce the loss threshold.
It is worth noting that most derivative exchanges allow option trades starting from BTC 0.10, with CME being the only exception.
Expected returns for a November $8.5K covered call. Source: Deribit
A 25% APY return can be achieved by selling 0.5 BTC $8K and 0.5 BTC $9K November call options. By reducing expected returns, one will only face negative outcomes below $8,370 at the November 27 expiry, 22% below the current spot price.
Take notice of how the $313 net profit stabilizes above $9K outcomes. To achieve this equilibrium, one needs to buy $8,187 worth of BTC, either via futures or regular spot markets. The call options premium will raise the remaining BTC 0.303 ($3,257), but only the option seller gets paid beforehand.
Implied volatility drives covered call returns
Implied volatility is options markets main risk gauge, and it increases as traders perceive a higher risk of sudden price moves. This indicator will increase regardless of investors’ optimism, as volatility relies exclusively on absolute price changes.
A constant daily 4% loss across a few weeks results in extremely low volatility, which would be the same as a fixed daily 4% gain. The volatility will increase in periods of extreme uncertainty; therefore, option sellers will demand a larger premium.
Bitcoin 3-month options implied volatility. Source: Skew
As Skew data shows, the BTC 3-month options implied volatility currently stands at a 59% annualized basis. Despite being relatively low, the figure is still enough to provide a 41% APY using covered call strategies.
Investors can benefit from a higher reading, but the risk of suffering losses using covered calls also increases. This reflects traders’ fear of unexpected price swings; therefore, an increased implied volatility indicates higher odds of an expiry price below the options strategies’ profit threshold.
All investments carry some degree of risk
All passive yield strategies have embedded risks. While it is possible to use a stop loss on covered calls, it should be noted that options markets can be reasonably illiquid during intense BTC price swings. This means it’s important here to never close futures or spot positions independently from the options.
DeFi might have its appeal, and even if one is willing to accept the risks associated with wrapped BTC, there are unknowns from faulty smart contracts, potential DeFi protocol breaches, clogs in the Ethereum network during peak traffic and the increased fees which can reduce profits and amplify losses. Outside individual pools and DeFi apps, there’s also room for oracle price sourcing manipulation which can cause cascading liquidations.
The main advantage of the covered call is it enables investors to set their own appetite for risk and have a clearer picture of their potential profits.
By opting for centralized solutions, investors can avoid high gas fees and the risk of being front run by wealthier or more savvy DeFi farmers.
The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph. Every investment and trading move involves risk. You should conduct your own research when making a decision.
