Enhancing returns and managing risk for holders of stocks, gold and Bitcoin

The core concept:

The derivatives industry is massive and is estimated to be over $1.2quadrillion in size and, while many think of derivatives as tool to enable one to leverage exposure to an asset, to enable speculation in reality the derivatives market plays a vital role in enabling business to manage risk and provide liquidity. NYIM remind us: “In finance, there are four basic types of derivatives: forward contracts, futures, swaps, and options.” Essentially, derivatives serve as powerful financial tools that enable companies to navigate uncertainties in markets, improve operational efficiency, and achieve strategic objectives while managing associated risks effectively. However, improper use or over-leveraging in derivatives can lead to significant financial losses, underscoring the importance of prudent risk management practices. While the derivatives market is huge typically, it is only used by sophisticated or institutional investors.

In the UK, the FCA details rules around the use of derivatives and, while many mutual funds are allowed to use derivatives for ‘efficient portfolio management’, the reality is that most retail funds tend not to. Forbes has reported that: “Bitcoin remains 4.5 times more volatile than the S&P 500 (7.88%) and four times more volatile than gold (8.92%).The more volatile an asset is the more uncertainty there is so the higher the cost is to get exposure to that asset.” Historically, Bitcoin’s annualized implied volatility often exceeds 70%-100%, whereas gold’s implied volatility typically ranges between 10%-20%. For example, call option to give exposure to on Bitcoin over the next month is likely to cost 5%-15% of the underlying price, while a similar option on gold might cost only 1%-3% of its underlying price. This volatility can be used to an investor’s advantage because, rather than buying a derivative such as an option, it is possible to be a seller of volatility, i.e. selling calls against your stock, gold or Bitcoin holdings - this is referred to as a ‘covered call strategy’. So, let us look at examples of doing this with gold, stock indices and Bitcoin to illustrate how investors can enhance returns and manage risk. Covered call writing involves owning an asset and selling call options on that asset. This generates income (premiums) but limits potential upside. Advanced strategies build upon this foundation.

Diagonal spreads with LEAPS for gold

This strategy uses long-term equity anticipation securities (LEAPS) to establish a long-term bullish position while generating income. LEAPS are very similar to traded options but have a longer time before they expire. As an example: buy a 2-year LEAPS call on gold (GLD) (gold ETF price $250) with a $250 strike price for $20 per share, and sell short-term (e.g., monthly) calls with a higher strike (e.g., $270) for $2 per share.

Enhanced returns - if GLD stays at $250 after one month, the short-term call expires worthless and you keep the $2 premium. This represents a 10% return ($2/$20) in one month.

Reduced cost basis - premiums collected from selling short-term calls help reduce the net cost of the LEAPS option.

Flexibility - offers flexibility to adjust strike prices and expirations based on market outlook. For example, if GLD rises to $270 and the short-term call is exercised, you sell your GLD shares at $270, but your LEAPS option has likely increased significantly in value. This could result in a 10% return from the short-term call plus the gain on the LEAPS option (($270-$250) +$2-$20)/$20 = 10% + LEAPS gain).

Limits upside potential - if gold prices rise significantly, your gains are capped by the short-term calls you sell.

LEAPS risk - if gold prices fall substantially, you could experience losses on your LEAPS option. For instance, if GLD drops to $245, the $2 premium offers a 10% return, but this is offset by the LEAPS option's loss in value.

Assignment risk - carries assignment risk, requiring the investor to sell their gold holdings if the short-term calls are exercised.

Covered calls and risk reversals for stock indices

This strategy combines writing an out-of-the-money put option and buying an out-of-the-money call at the same time. As an example, a fund manager, moderately bearish on the S&P 500 (currently at 5998.72), sells a short-term (e.g., March 20, 2015, expiry) call option with a 6020-strike price, receiving a premium of 205.1 index points per option. They then use this premium to buy a put option with a 6,000-strike price for 132.1 index points.

Generates income - the manager benefits from any upward movement until the index hits 6225.1

(strike price + premium received). If the S&P 500 doesn't reach 6020 by expiry, they keep the entire premium, outperforming a buy-and-hold strategy.

Downside protection - the purchased put option provides downside protection if the market falls

significantly.

Underperformance - this strategy underperforms if the market experiences a significant rally beyond 6225.1.

Balancing risk and reward - requires careful selection of strike prices and expirations.

Covered call writing on Bitcoin ETFs (e.g., using Blackrock’s Bitcoin ETF- iBIT)

For some Bitcoin investors, they use derivatives as a form of insurance to protect them from large falls or to give them exposure to a rapid increase in the price of BTC. With the emergence of Bitcoin ETFs like Blackrock's iBIT, investors can now apply covered call strategies to this asset class. As an example, an investor holding iBIT shares could sell call options with a strike price above their purchase price. This generates premium income and provides a degree of downside protection.

Income generation - earn premiums while maintaining a long-term position in Bitcoin.

Reduced cost basis - premiums collected can effectively reduce the cost basis of the iBIT shares.

Missed opportunities - if Bitcoin's price surges, potential gains are capped at the strike price of the sold call option.

Assignment risk - if the option is exercised, the investor must sell their iBIT shares at the strike price, potentially missing out on further upside.

Active management - these strategies require active monitoring and adjustment of positions based on market conditions.

Commissions and taxes - calculations should account for these factors, which can significantly

impact returns.

Time decay - options lose value over time (theta decay), which can impact the profitability of these strategies.

Advanced covered call strategies offer investors tools to potentially enhance returns and manage risk across various asset classes, including gold, stock indices, and Bitcoin ETFs. However, they require careful planning, monitoring and an understanding of the underlying assets and options markets. By combining LEAPS, short-term calls and put options, investors can tailor strategies to their specific market outlook and risk tolerance. As markets grow more turbulent and unpredictable, derivatives offer both shelter and risk. Investors have a choice master these tools or rely of professionals and let them navigate these complex tools on your behalf. Remember volatility isn’t just a threat - it can be a prize too. So, are you ready to engage?

This article first appeared in Digital Bytes (3rd of December, 2024), a weekly newsletter by Jonny Fry of Team Blockchain.