The attraction of the ratio write is the potential for higher premium income. Traders too often convince themselves that exercise is unlikely, and that time decay is likely to outpace intrinsic value as the stock goes higher, even if the calls go in the money.
Here's the thinking: You own shares of an underlying security. You sell to open ATM, OTM or slightly ITM (At, Out of or In The-Money) call positions with one to two months until expiration. A ratio write is defined as a strategy in which you sell more call options than shares will cover. In essence, you would have a small naked call position (check with your brokerage firm to see if you are qualified to do this in your trading account). ATM and OTM option premium is all time value and extrinsic value (implied volatility). The expectation is that this time premium will evaporate very quickly, so even if the underlying price rises, you can close the exposed portion of the ratio and escape a net loss. Or you can roll the exposed positions forward, or forward and up in strike price.
The problem occurs when the underlying price rises so rapidly that you find yourself suddenly exposed to an expensive exercise loss. You have to either close the exposed (naked short) calls at a loss or roll them forward or up to a higher strike price.
When you roll up you are moving your short option position further out of harm's way, so isn't that a great solution?
No, because in this scenario it is highly likely that the one-to-one calls left are going to be exercised, meaning all of your underlying shares will be called away. Then you're left with those rolled uncovered, short calls. Another factor to keep in mind: Any uncovered calls require collateral equal to the full strike value. So if you write calls at 35 strikes, each uncovered option requires $3,500 collateral on deposit.
So much for the low-risk strategy.
A partial solution is found in the variable ratio write. Use two strikes instead of one, and you set up a more effective buffer zone. The lower strike should be ATM or slightly OTM, and the ideal higher strike will be either one point or 2.5 points higher. Use one- to two-month expirations to maximize time decay.
Here's an example of a variable write. You own 600 shares of stock at $40. You would be satisfied with losing some or all of the shares if they were assigned. Sell 4 of the 45-day 40 strike calls and sell 4 of the 45-day 42.50 calls. The credit received is all time value premium, and the 40 strike calls being ATM have the most time value premium. Two of the calls are uncovered. If the underlying begins moving towards 42.50, you can close the higher strike calls, perhaps at a profit (depending on time until expiration and time decay), and avoid the unpleasant prospects of big losses due to the shares moving even higher or an uncovered exercise. Or, you could roll the 42.50 calls to the 45 strike calls with the same expiration or a later expiration.
The variable expansion of the ratio write reduces risks significantly; but it does not eliminate them. You have to be willing to live with the risk of a sudden, significant movement in the underlying. And if you do end up having to roll out of exercise danger, you may want to consider rolling the higher strike calls to a later-expiring variable write (rolling the 45-day 42.50 calls to the 75-day 45 strike calls - rolling up and out). This at least defers exercise while generating more income. Hopefully, you can wait for time decay to make your roll profitable. But as an options trader, that one word -- hopefully -- too often is the downfall of a strategy that looked good on paper.
Don't overlook the collateral requirements for uncovered options. To read more about this, download the free report at CBOE Margin Manual
The variable ratio write looks like a great strategy, and it is easy to overlook the risks it involves, not to mention the collateral requirement equal to 100% of the strike value. By the way, if you roll uncovered short calls to a higher strike, your collateral requirement goes up, too.
Michael Thomsett blogs at the CBOE Options Hub and several other sites. He is author of 11 options books and has been trading options for 35 years. He also has developed a course on the topic of using candlestick signals to time trades. You can discover the world of effective chart reading with Profitable Trading Strategies Using Candlestick Charting. This is a comprehensive and complete course on the nature of candlestick charting, offered exclusively by the Global Risk Management Community. By the conclusion of this course, you should be able to locate actionable candlestick signals, better understand what is likely to occur next, and combine candlesticks with other technical signals to forecast price movement. To find out more, go to Using Candlestick Charting
Comments
You are welcome. These topics can become complex and careful definition of terms and explanation of trading mechanism are essential in development of assets and pricing models. I appreciate your feedback. I hope you will also take a look at the candlestick charting course I offer exclusively on Global Risk Management.
Michael,Thanks so much for these clarifications on the subject matter.I have thought Derivatives:Properties and pricing.Call and put options are part of the content of this module.
Thank you for your comments. I would expand on the definition of calls and puts by pointing out that both can be bought or sold. In other words when you buy a call, you buy the right to buy shares; and when you buy a put you buy the right to sell shares. However, when you sell either option, you are granting those rights to the buyer on the other side.
ITM means "in the money," OTM is "out of the money" and ATM is "at the money. It all refers to the relationship between an option's fixed strike and the current price of stock. A call is out of the money when the stock price is lower than the strike, or in the money when the stock price is higher. When both are the same, the call is at the money. It is opposite for a put. When the stock is lower than the put's strike, the put is in the money. When the stock price is higher than the strike, the put is out of the money. And of course, when the underlying security's price is identical to the put's strike, the put is at the money.
You are correct, owning an option grants you a right but not an obligation. The exercise price is also known as the strike or strike price. It is the fixed price at which exercise would occur if the option is exercised by its owner. In that case, the owner calls the stock (with a call) or puts the stock to the seller (with a put).
This is interesting.I am aware that call and put options can be written on equities and bonds as reference entities .Call and put options are essentially derivatives.Whereas option to buy is call option ,option to sell is a put option.
The option is the less forward type of derivatives. Although the forward or future contract implies an obligation to trade once the contract is enforced into the option (as its name suggests) gives the agent who is long a right but not an obligation to buy or sell a given asset at a pre-specified price. This price is known as exercise price and is specified in the option contract. Just as with the forward, another factor specified in the contract is the date on which the exchange is to take place. If on the maturity date, the holder of the option decides to buy or sell in line with the terms of the contract he or she is said to have exercised his or her right. A difference between forwards and options is that with an option the agent who is long must pay a price (or premium) at the outset. This is essentially a price paid by the holder for the exercise choice he or she faces at maturity.
Options to buy a specified asset are called call options. Options to sell are called puts. Another distinction is made on the timing of the exercise decision. With European options the right can only be exercised on maturity date itself. With American options in contrast, the option can be exercised on any day on or before maturity.However,i appreciated the authors view in the above write -up that variable of ratio write reduces risks significantly but it does no eliminate them;A partial solution is found in the variable ratio write.Use two sticks instead of one and set up a more effective buffer zone. I also noted the author's definition of ratio write which means a strategy in which you sell more call options than shares will cover.Please,enlighten me on the meaning of ATM, OTM or strictly ITM.Thanks.