MarketInOut Stock Screener Please enable JavaScript to view this page content properly Log In | Sign Up
Article Directory

The Ratio Write: Expanding the Covered Call
by Michael Thomsett

Options traders will agree that covered call writing is profitable and conservative. This article proposes an expansion of the theory, and demonstrates that a ratio write yields more profit without adding significantly to market risk.

Covered calls provide safe and consistent current income. Time favors selling calls and owning 100 shares of stock for each short call protects against losses resulting from exercise. The only risk above and beyond the risk of just owning stock is the occasional lost opportunity. When stock prices soar far above the short call’s strike, shares are called away and profits are limited. However, covered call writers recognize that most of the time the positions are going to be profitable. But is that the best you can do?

Ratio writing to increase covered call profits

Another way to use covered calls is with the ratio write. Under this strategy, you sell more calls than you cover. For example, if you own 300 shares and sell four calls, you create a 4-to-3 ratio write. You can look at this as three covered calls and one uncovered call; or as four calls that are all covered 75% instead of 100%.

This strategy works best when implied volatility is high. This means that option premium is quite rich, so you will get more income than when implied volatility is "normal" or below. When implied volatility is high, it usually adjusts fairly quickly, in recognition of the market’s tendency to over-react to stock price volatility in the short term. So if you write short calls when volatility is high, you can close all or some of them once volatility declines. This means premium levels decline as well, so the ratio write is a sensible timing strategy.

Although this theory summarizes the strategy, it does not always work out as planned. There is always the threat that the underlying stock’s market value will rise above the option strikes. In that event, you may have all of the short calls exercised. The risk is equal to the current price of stock at the time of exercise, minus the strike price, minus premium income. For example, if the strike is 40 and a 4-to-3 ratio write is entered, exercise of all four may result in a loss. If you receive $400 in premium by selling four 40 strike calls at 1 ($100), and the stock price rises to $47, what happens? Three of the four calls are covered; but the one remaining call is exercised for a loss of $700 (current value of $47 minus strike of $40). The loss is $300 (premium income of $400 subtracted from loss on the uncovered call of $700).

This outcome can be avoided by closing the position after value has declined with a "buy to close" order. It can also be avoided or deferred by rolling forward (closing one of the calls and replacing it with a later-expiring one). In other words, you do not have to leave the positions open and just hope for the best.

The variable ratio write

Risk can be even further reduced by created a ratio write with more than one strike. For example, instead of selling four 40 strike calls, you can sell two 40 and two 42.50 strikes. Now the situation is changed significantly. In the event the stock goes in the money for the 40 strikes, one or both of the 42.50 positions can be closed or rolled. The likelihood of declining time value makes this practical at breakeven or even at a small profit. When the excess ratio portion is closed, it removes the additional risk altogether.

The variable ratio write is even more interesting when one or both strikes are rolled forward. The roll avoids exercise and adds to premium income. So exercise is not difficult to avoid or defer. Remember, however, that while exercise is most likely right before expiration, it can happen at any time. So when a ratio write or variable ratio write is in-the-money, exercise can take place.

A final version of the variable write removes the excess risk exposure. In this strategy, you cover the exposed short call with a high-strike long call. As long as the net premium credit produces a credit even with exercise, this is an interesting and safe strategy. For example, you own 300 shares and you enter a variable ratio write with two 40 and two 42.50 strike short calls. You also buy one long 45 call. Given the fact that the 45 is far out of the money (assuming current value of stock at the time you entered the position was at or below $40 per share), the 45 call will be very cheap. In the worst-case outcome, all four of the short calls are exercised, creating a loss in the exposed call. In the previous example, that loss was $300. If you also hold a single long call 2.5 points above the highest strike (45 versus 42.50), you can cover the exposed short call with the long call for a loss of $250. So if you bought the call for 0.50 or less, you will have to loss.

This strategy is valuable if you are concerned about a substantial upward movement in the underlying stock. That is an unlikely outcome, of course; but it can happen. The long call cover of the exposed short position eliminates your worst-case risk. To accurately judge whether or not it is sensible, compare the expanded variable write strategy to the outcome of a simple covered call without the ratio features.

A ratio write is an interesting expansion of the covered call. It provides potential for much higher premium income for minimal added risk. Careful monitoring and selection -- especially employing the variable ratio write -- adds an important element of flexibility to the strategy. As with any options strategy, you have to understand the risks involved before entering the position. The ratio write will work for many, but not all, options traders. It is only one example of how options offer many permutations of income potential and creative strategic nuances to covered call writing.

About the Author

Michael C. Thomsett is author of Getting Started in Options, Trading with Candlesticks and numerous other books on technical analysis, stock trading and options.

 Return to Previous Page - Stock Screener
Stop Loss, %
  Take Profit, %
 Trade Alert
 Technical Analyzer
 Stock Screener

Disclaimer - Privacy Policy - Cookie Use Policy - FAQ - Contact Us
Copyright ©2008-2024 All rights reserved.