The attraction of the ratio write is the potential for higher premium income. However, ratio writes do increase risks. Options traders too often convince themselves that exercise is unlikely, and that time decay is "likely" to outpace intrinsic value even if the calls go in the money.
Here's the thinking: You open ATM or ITM positions with one to two months until expiration. It's all time value, so that will evaporate very quickly. 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.
The problem occurs when the underlying price rises so rapidly that you find yourself suddenly in the money with a combined covered and uncovered options position. You have to either close the exposed calls at a loss, cover them, or roll them forward.
When you roll, you receive more premium, 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 ITM calls. And they're uncovered.
So much for the low-risk strategy.
The solution is mitigated by writing 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. But if the underlying begins moving in on the strikes, you can buy to close the higher-strike calls, often at a profit, and avoid the unpleasant prospects of big losses due to uncovered exercise.
The variable expansion of the ratio write reduces risks significantly; but it does not eliminate them. You do have to be willing to live with the risk of sudden, significant movement in the underlying. And if you do end up having to roll out of exercise danger, roll all of the calls to a later-expiring variable write. 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.
Any time you open positions with uncovered short options, you need to be aware of the collateral requirements. To find out more about this, get the free download at CBOE Margin Manual.
The ratio write is one of many possible strategies, but it involves substantial market risks. The variable ratio write reduces the risk, but does not eliminate it.
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