Ratio Call Write Explained

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Ratio Call Write

What Is a Ratio Call Write?

A ratio call write is an option strategy similar to a covered call, but where an investor owns shares in the underlying stock and then sells (writes) more call options than the amount of underlying shares owned. The goal of a ratio call write is to capture the additional premiums received by the option sales. The call writer hopes that there is little volatility in the underlying stock over the same period.

A ratio call write falls under the broader category of options strategies known as buy-writes.

Key Takeaways

  • A ratio call write involves selling upside call options while being long the underlying asset, but in a ratio where the calls exceed the long position.
  • A ratio call write is essentially a covered call with additional short calls.
  • The strategy maximizes payoff if the underlying asset’s price is just under the calls strike price at expiration, but provides unlimited loss potential if the underlying asset rallies through the strike price.

How Ratio Call Writes Work

A covered call is a strategy whereby the owner of the underlying asset sells call options at an equal or higher strike price to where the stock is currently trading, in a 1:1 manner. The purpose is to generate extra income from the premiums collected from the sale of the option. The strategy pays off most when the stock does not change from its current level, since the call will eventually expire worthless and the investor will still own the shares while collecting the entire options premium. However, writing covered calls limits the upside potential since the short calls will be assigned and any gains in the stock above the strike price will be offset by the short call.

In ratio call writing, the ratio represents the amount of options sold for every 100 shares owned in the underlying stock. For example, a 3:1 ratio call write implies writing three call option contracts (representing a total of 300 shares) and being long one hundred shares of the asset. The payoff from holding the asset and writing the calls resembles a traditional covered call, except the potential profit is amplified. At the same time, the potential loss becomes infinite, since the investor essentially has a 1:1 covered call position and then is short two more calls naked. These naked shorts have an unlimited loss if the price of the stock goes up and up.

Thus, the profit range for ratio call writes is often very narrow. A large drop in price may end up costing the trader a considerable sum of money in the shares that exceeds the amount of premium collected. If the price of the underlying shares increases too much, the trader will also lose, as explained above.

Example of a Ratio Call Write

For example, if an investor has 1,000 shares of XYZ, which is trading at $50, he may sell 10x of the 60 strike call option expiring in 3 months. This would be a covered call. In a ratio call write, he or she would sell more than 10x, say 25x, of the 60 strike call.

As long as XYZ stock remains below $60, the investor will remain profitable, since the call options will expire worthless and they will collect the entire premium of the 25 options that were sold. If, however, the price of XYZ stock rises substantially above $60, the investor will lose money since the long stock position is not fully hedged against the larger amount of short calls which become in-the-money.

Variable Ratio Write Definition

What Is the Variable Ratio Write?

The variable ratio write is an options strategy defined by an investor or trader holding a long position in the underlying asset while simultaneously writing multiple call options at varying strike prices. It is essentially a ratio buy-write strategy.

Variable ratio writes have limited profit potential because the trader is only looking to capture the premiums paid for the call options. This strategy is best used on stocks with little expected volatility, particularly in the near term.

Variable Ratio Writes Explained

In ratio call writing, the ratio represents the number of options sold for every 100 shares owned in the underlying stock. This strategy is similar to a ratio call write, but instead of writing at-the-money calls, the trader will write both in the money and out of the money calls. For example, in a 2:1 variable ratio write, the trader will be long 100 shares of the underlying stock. Two calls are written: one is out of the money and one is in the money. The payoff in a variable ratio write resembles that of a reverse strangle.

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As an investment strategy, the variable ratio write technique should be avoided by inexperienced options traders as this strategy has unlimited risk potential. Because losses begin when stock price makes a strong move to the upside or downside beyond the upper and lower breakeven points, there is no limit to the maximum possible loss on a variable ratio write position. Although the strategy appears to present significant risks, the variable ratio write technique does offer a fair amount of flexibility with managed market risk, while providing attractive income for an experienced trader.

There are two breakeven points for a variable ratio write position. These breakeven points can be found as follows:

Real World Example of a Variable Ratio Write

Take as a hypothetical example an investor who believes XYZ stock (which is trading at $100) is unlikely to move very much over the next two months. As an investor, he is unlikely to add or reduce his stock position, where he owns 1,000 XYZ shares. However, he can still generate a positive return if his prediction is correct by initiating a variable ratio write by selling 30 of the 110 strike calls on XYZ that are due to expire in two month’s time. The options premium on the 110 calls are $0.25, and so our investor will collect $750 from selling the options.

After two months, if XYZ shares indeed remain below $110, then the investor will book the entire $750 premium as profit, since the calls will expire worthless. If the shares rise above the breakeven $110.25, however, the gains on the long stock position will be more than offset by losses by the short calls, for which he has sold more (representing 3,000 shares of XYZ) than he owns.

Ratio Call Write

The ratio call write is a neutral strategy in options trading in which the options trader owns a holding of the underlying stock and sells more calls than shares owned. It is a limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the underlying stock price will experience little volatility in the near term.

Ratio Call Write Construction
Long 100 Shares
Sell 2 ATM Calls

A 2:1 call ratio write can be implemented by selling 2 at-the-money calls for every 100 shares owned.

Limited Profit Potential

Maximum profit for the ratio call write is limited and is made when the underlying stock price at expiration is at the strike price of the options sold. At this price, both the written calls expire worthless while the value of the long stock position remains unchanged. As such, the options trader gets to keep all of the premiums received when putting on the trade. Thus, maximum profit is equal to the premiums received from the sale of call options.

The formula for calculating maximum profit is given below:

  • Max Profit = Net Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Short Calls

Unlimited Risk Potential

Loss occurs when the stock price makes a strong move to the upside or downside beyond the upper and lower breakeven points. There is no limit to the maximum possible loss for the ratio call write.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying Strike Price of Short Call + Net Premium Received
  • Loss = Price of Underlying – Strike Price of Short Call – Net Premium Received OR Purchase Price of Underlying – Price of Underlying – Net Premium Received + Commissions Paid

Breakeven Point(s)

There are 2 break-even points for the ratio call write position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Strike Price of Short Calls + Points of Maximum Profit
  • Lower Breakeven Point = Strike Price of Short Calls – Points of Maximum Profit

Using the graph shown above, since the maximum profit is $400, points of maximum profit is therefore equals to 4. Therefore, upper breakeven is at $49 while lower breakeven is at $41.

Example

Suppose XYZ stock is trading at $45 in June. An options trader executes a 2:1 ratio call write strategy by buying 100 shares of XYZ stock for $4500 and selling two at-the-money JUL 45 calls for $200 each for a total of $400.

On expiration in July, if XYZ stock is still trading at $45, both the JUL 45 calls expire worthless while the long stock position is still worth $4500. At this point, the options trader is positive $400 in the money because of the premiums earned. He can then choose to enter another ratio write or sell the shares and take profit.

If XYZ stock rallies and is trading at $49 on expiration in July, all the call options will expire in the money. The two written JUL 45 call are now worth $400 each. This $800 loss is completely offset by the $400 appreciation of his long stock position and the $400 in premiums he received earlier. Therefore, he achieves breakeven at $49.

Beyond $49 though, there will be no limit to the loss possible. For example, at $60, each written JUL 45 call will be worth $1500, resulting in a combined loss of $3000 on the short position. Meanwhile, his long stock position has only appreciated by $1500 and together with the $400 in premium received, the options trader still need to come up with another $1100 to close the position.

Using the formula for computing the breakeven point, we calculated the lower breakeven point to be $41. At $41, all the call options expire worthless. However, his long stock position also suffers a loss of $400 in value but this loss is offset by the $400 in premiums earned. Therefore, there is breakeven at $41.

Below $41 however, there is no limit to the potential loss. For example, if the stock price is trading at $30 on expiration, while all the call options expire worthless, the long stock position suffers a $1500 drop in value. Even with the $400 in premiums to offset the loss, the options trader still suffers a $1100 loss.

Note: While we have covered the use of this strategy with reference to stock options, the ratio call write is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the ratio call write in that they are also low volatility strategies that have limited profit potential and unlimited risk.

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