Covered Calls and Assignment
Your collateral backs covered calls that Spout writes on your asset's pool. This is what makes the loan free. The one thing you give up is upside above the strike, and only in a cycle where the calls are exercised.
What a call on your collateral means
For each cycle, Spout sells listed calls on the shares behind the pool, on US options exchanges through its brokerage account, at a strike set out of the money, meaning above the current price. One call covers 100 shares, so calls are written in whole lots of 100. If a pool holds fewer than 100 shares, no calls are written on that asset until it grows, and borrowers in it still borrow at 0%.
The three outcomes of a cycle
| At expiry, the stock is | What happens to you |
|---|---|
| Below its starting price | The calls expire unused. You keep all your tokens. Your loss is the same as if you just held the stock. |
| Up, but below the strike | The calls expire unused. You keep all your tokens and all of the gain. |
| Above the strike | The calls are exercised (assignment). You keep the gain up to the strike and give up the move above it. |
What happens on assignment
- The called shares are delivered from Spout's brokerage account at the strike price, and their receipt tokens are burned.
- Spout uses the strike proceeds to buy the shares back in its brokerage account when the market next trades, and matching receipt tokens are minted back into the pool.
- Because the buy back usually costs more than the strike, the pool ends with slightly fewer receipt tokens, so each position holds slightly fewer tokens. Every position in that asset shares the difference in proportion to its collateral that was in that cycle.
- Your loan does not change.
Collateral added since the cycle started is not covered by that cycle's calls, so it is not affected. Because the buy back happens at the next market price, the final result depends on where the stock trades then; it can come out slightly better or worse than the expiry price suggests.
A worked example
Say the strike was $110 and the stock finished the cycle at $115, and calls covered the whole pool.
- Each called share returns $110, which buys back about 0.957 shares at $115.
- Your 100 tokens become about 95.7 tokens, worth about $11,000.
- Had the stock been capped at $110, your 100 tokens would also be worth $11,000.
You kept every dollar of the rise up to $110 and gave up the move from $110 to $115 on the called shares.
Who gets the premium
The premium from the calls goes to lenders, the Insurance Fund and the treasury, not to you. What you get in return is a loan with no interest. Strikes are set with the aim that assignment is uncommon and most cycles leave borrowers untouched.