Variable Ratio Writes

12/12/2014 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

Option trader Michael Thomsett of ThomsettOptions.com highlights the reasons for ratio writes—writing more calls than are covered—but he also goes one step further by defining and explaining the benefits of the ‘variable ratio write’ options strategy.

Covered call writers are forever trying to find new ways to expand income, but without the accompanying higher risk.  The ratio write—writing more calls than are covered—does this to a degree, but not enough.

For example, if you own 300 shares of stock purchased at $33 and currently priced at $35.50, you could write covered calls. Assume the two-month 35 calls are worth 1.82. So, a straight covered call with three contracts yields $546. Even though the calls are in-the-money (meaning current price is above $35), the premium is rich enough to make it work—and anyhow—the example’s basis in stock was $33, so exercise yields a 2-point profit.

A ratio write may involve writing four calls, for example. In that case, call income goes up to $728. This 4:3 ratio is fairly safe because one or more positions can be closed or rolled forward.

Still, the ratio write contains an element of market risk.

The variable ratio write is the same idea, but involves two strikes. For example, you may write two of the 35 calls and get $364, as well as two 36 calls, at 1.28 each, and earn another $256. Total income: $621.

The advantage in this strategy is that the high-strike calls are out-of-the-money. Time value is going to evaporate and as long as the calls remain out of the money, exercise risk does not apply.

If stock price does rise, you can take several actions: Close one or more of the calls, roll them forward, or cover the exposed contract (by buying 100 more shares or buying an offsetting long call).

The variable ratio write gives you much more flexibility and reduces the market risk considerably, while providing nice income. The variable ratio write is one example of how risks can be managed. At first glance, it might seem high-risk, but considering how it is managed by an astute trader, it is not.

By Michael Thomsett of ThomsettOptions.com

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