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.

If ETH were trading at $1500, one might write 10 call options with a strike price of $1600. In the case of a naked call, the option writer might hold $15000 USDC as collateral; in the case of a covered call, the option writer would hold 10 ETH as collateral. If the price increased to $2200 before the options were exercised, the naked call writer would have to buy ETH from the market for $600 more (per unit) than they receive, resulting in a $6000 loss less premiums. On the other hand, the covered call writer would already have the ETH needed to fulfil the calls, and would still walk away with a dollar profit equivalent to the premiums received when writing the options.

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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