The Covered Call Ratio Write — the Portfolio Cash Cow

By Michael Thomsett | TradingMarkets.com | April 08, 2011 12:57 PMĀ 

 

Summary:

The covered call strategy has two parts: 100 shares of long stock, offset by one short call. If the short call is exercised, the 100 shares are called away. The ownership of shares eliminates the risks associated with the short position, which if uncovered presents a high-risk strategy.

Beyond the covered call, it is possible to vary risk and to increase the cash income from selling calls, with the ratio write. This allows the writer to manage risks and to alter the strategy if and when the positions go in the money — by closing the ratio excess or by rolling them forward. This strategy improves control and helps call writers to creatively expand the basic covered call strategy.

Definitions:

The ratio write is a combination of blocks of 100 shares and an offset of short calls at a greater n umber than one-to-one coverage provides. For example, a two-to-one ratio write is a combination of two short calls and 100 shares of stock. Another type, the variable ratio write, is a split between short calls, with strike prices both above and below the current value of stock. For example, stock is current worth $62.50 per share. An investor who owns 100 shares may sell two calls, one with a strike of 60 and another with a strike of 65. This creates a variable ratio write.

Rules:

The overall risk of the ratio write has to be the determining factor. The question of whether or not the strategy is a good match relies completely on how well the trader manages the relative exercise risks inherent in the strategy. Remember: the ratio write is a partially uncovered short position no matter what name it is given. The overall position is either covered to a degree (for example, a 4:3 ratio write is 75% covered because there are 300 shares and four short calls). The position is also the combination of three covered calls and one uncovered call.

Proximity between current price and strike defines risk and its evolving nature as expiration approaches. As long as short calls are out of the money, there is no chance of exercise. As the market value approaches strike, exercise risk increases and if the market value exceeds the strike and remains there, exercise will surely occur by expiration. This means a secondary rule applies: A ratio write exposes you to exercise risk assuming that short calls end up in the money. This risk is mitigated or eliminated in one of three ways: Closing the position, rolling forward, or offsetting the short with an offsetting long call position that expires on the same date or later.

How the Ratio Write Works

The process for opening a ratio write is the same as that for opening a covered call. Traders own a specific number of shares and sell calls that are covered by those shares. In a covered call, a trader who owns 200 shares sells two calls and achieves 100% coverage. If the same trader sells three calls, the result is a 3:2 ratio write — three calls written against 200 shares of stock.

The larger the number of shares, the less risk involved in the ratio write. For example, a 2:1 ratio write involves cover for only one-half of the shares. It consists of two short calls and 100 shares. In comparison, a 3:2 is 67% covered (2/3) and a 4:3 ratio is 75% covered (3/4). So an investor with 200 or 300 shares is more suited to the ratio write than an investor holding only 100 shares. The relative levels of risk should be kept in mind when analyzing the value of ratio writes as an expansion of the basic covered call.

The ratio write also further discounts the basis in stock, reducing market risk. For example, if you buy 100 shares of stock at $50 per share and sell a call for 3 ($300), that reduces the true basis to $47 per share. If the short call is exercised, stock is called away at the strike; if it expires or is later closed, the net call premium is profit. With a ratio write, this discounting benefit is increased. For example, if you own 300 shares bought at $40 per share and you sell four calls at 3 each, you are credited $1,200, which reduces your basis in the stock by four points ($1,200/300 shares). The net basis in stock is reduced to $46 per share.

So even while the ratio write exposes you to additional exercise risk, it also reduces your basis in stock. This offsetting risk element demonstrates why the ratio write makes sense, even to a conservative trader inclined to limit options activity to covered call writing.

Yet another way to reduce risk is to sell the ratio write and then buy one call at a higher strike. For example, on expiration date in February, Caterpillar (CAT) was trading in the range between $57 and $58 per share. When it was at $57.43 at mid-morning, the following options were available:

CAT March 57.50 calls, 2.23
CAT March 60 calls, 0.60

Assuming the original basis in stock was at or below the $57.50 strike, a ratio write could be opening based on ownership of 300 shares, and selling four calls:

Four 57.50 calls @ 2.23 = $892

Because current market value was close to the strike, there is always the risk that the price would move above that level, resulting in the threat of exercise. If that occurred, three of the contracts were covered but one was short. To limit this risk, you could offset the short position with one long call:

Four 57.50 calls @ 2.23 = $892
Less: one long 60 call @ 0.43 = $43

Now the net credit for this position was $849. In the worst-case outcome, with all four short calls exercised, three are covered by stock and the fourth is offset by the 60 long. The loss on this is the difference between the current price of stock when the position was opened, and the strike of the long position: 60 – 57.43 = $257

Upon exercise, the net premium on call positions of $849 would be reduced by the loss of $257, resulting in a net profit of $592. In comparison, simply entering a covered call position with three calls against 300 shares of stock would have resulted in net premium income of $669 (2.23 x 3), which is higher by $77 than the worst-case outcome for the ratio write. But is the worst-case worth the $77? That is the question. In actual application, there is always the chance that the short positions could be closed at a profit, or rolled forward.

If rolled forward, an interesting secondary strategy occurs. Assuming the stock is continuing to rise, the four rolled contracts avoid exercise by rolling, but the remaining long call could become profitable due to the rising stock price. There are many possible outcomes to this strategy beyond exercise. The ratio write is less risky than it might appear at first glance, especially when employing 300 or more shares of stock.

The Variable Ratio Write

Another variation is the variable ratio write. In this application, you sell calls at different strikes. For example, if you own 300 shares of stock currently worth $32.50, a variable ratio write may consist of two calls sold at a strike of 30 and another two sold at a strike of 35. This approach is most advantageous when the price of stock resides about halfway between two strikes.

The variable strategy combines an in-the-money and an out-of-the-money position against stock. This means that the in-the-money calls (in the example the 30 strikes) are more likely to be exercised, whereas the out-of-the-money have absolutely no intrinsic value and risk is much more remote. Both short positions are going to suffer time decay, especially if expiration will occur within the next two to three months. Analyzing likely outcomes demonstrates that the breakeven is going to reply on a discounted basis level of stock given the variable write positions. Rolling to avoid exercise is a good possibility if the stock’s price rises. If the stock price falls, either of the call positions can be closed at a profit. The in-the-money calls will lose value rapidly because intrinsic value will suffer in mirroring the stock decline. Out-of-the-money strikes will also decline as long as current value of stock remains below the strike.

The point to remember about ratio writes is that they open up a broad range of strategic possibilities. The higher the number of shares you own, the less risk in the position. So for those holding multiple lots of 100 shares, the ratio write can serve as a manageable risk-level strategy that generates attractive profits.

For example, if you own 100 shares of stock current worth $30 per share, you could just sell 10 calls and gain profits whether exercised, expired or closed. But if you enter a ladder strategy and create a variable ratio with all positions higher than current value of stock, you can vastly improve your income. For example, you could sell the following contracts:

four 27.50 calls
four 30 calls
four 32.50 calls

This creates premium income from 12 short calls, but how much risk is really being taken on? Even if the 27.50 and 30 strike calls are exercised, the 32.50 can be rolled forward, closed or offset with long call positions. Risk does not disappear, but the variable write does make it more remote.

Ratio writing is interesting because it provides endless variation in how covered call writing is structured. It is enhanced even more with spread strategies involving both short and long calls, or put and call contracts. The potential is limited only by your ability to manage risk, and by your imagination.

Michael C. Thomsett is author of over 70 books in the areas of real estate, stock market investment, and business management. His latest book is The Options Trading Body of Knowledge: The Definitive Source for Information About the Options Industry. Thomsett’s other best-selling books have sold over one million copies in total. These are Getting Started in Options, The Mathematics of Investing, and Getting Started in Real Estate Investing (John Wiley & Sons), Builders Guide to Accounting (Craftsman), How to Buy a House, Condo or Co-Op (Consumer Reports Books), and Little Black Book of Business Meetings (Amacom). Thomsett’s website is www.MichaelThomsett.com. He lives in Nashville, Tennessee and writes full-time.

 

Thursday, August 18th, 2011 Education, Evergreen, Options, Stock Trading

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