Covered Calls
In theory, it's possible to write call options without holding any of the underlying asset. These are called naked calls, and have unlimited downside for the option writer if price rises significantly, since they will eventually need to buy the asset to fulfil the contract (or have their collateral liquidated).
In contrast, covered calls are call options sold while holding an equivalent spot position in an asset. Even if the price of that asset rises significantly, the option writer will always be able to fulfil the contract with their spot position. As a result, covered calls have substantially less downside.
Covered calls are an excellent way to generate yield on spot positions -- while maintaining a bullish outlook on those assets -- and are the cornerstone of many structured products, including Knox Finance's risk-adjusted vaults.
Risks of Covered Calls
Although covered calls are considered a low-risk strategy, there are still some risks associated with them.
Firstly, the underlying asset may decrease in value, causing the dollar value of the spot position to decrease. As a result, covered calls make the most sense for those who already have exposure to the asset, and want to maintain that exposure.
Secondly, the underlying asset may significantly increase in value beyond the strike price. In this case, the options will almost certainly be exercised, and the option writer will lose out on any appreciation above the strike price. In the example provided earlier, the covered call writer still profits in dollar terms, but loses out on the appreciation between $1600 and $2200.
Knox Finance vaults are primarily designed for those looking to maintain bullish (or bearish) exposure to an asset, nullifying the former risk. Additionally, they are carefully structured to minimize the latter risk, as discussed on the next page.
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