Market Overview

Ratio Writes: Evaluating the Risks

One of the amazing points about options is the flexibility they bring to trading. But is it possible to develop a strategy that holds risk down to a nice low level, while increasing profits?

Yes.

In fact, there are many conservative trades possible with options. A definition of “conservative” that I use is:

Conservative: a strategy or series of strategies that reduce risk while increasing income.

There are numerous possibilities, but one that is especially intriguing is the ratio write. In this strategy, you write more calls than you cover. In the traditional covered calls, you sell one call per 100 shares. In the ratio write, you exceed this. For example, if you own 300 shares and you sell four calls, it sets up a 4:3 ratio write.

For example, on March 21, 2012 Adobe Systems (NASDAQ: ADBE) closed at $33.56. If you had bought 300 shares three months ago when the stock was as low as $27.40, you have a six-point appreciation in the position. Rather than taking profits, you decide to write a 4:3 ratio write. You sell four of the May 34 contracts at 1.12, collecting $448 before trading costs. That discounts your current position to $32.07 per share:

  • Stock: $3,356 x 300 = $10,068
  • 4 calls premium income = $448
  • Net basis = $9,620
  • $9,620 ÷ 3 = $3,206.67

This is a nice discount, created by the ratio write premium income. You can look at this as three covered calls and one uncovered call. Or you can think of it as a position that is 75% covered.

When does the ratio write make sense? First of all, the strike should be higher than your basis in the stock and, in the best scenario, slightly out of the money. Expiration should not be too far off; the ideal is expiration in less than two months because this is when time decay is most accelerated. So in this set-up, time is on your side. As the time value declines, you can close one or more of the short positions, take profits and completely eliminate that excess risk.

But it gets better.

If you write a variable ratio write, you can control the position even better and avoid exercise while getting extra profits. The variable ratio write involves using two strikes, so that the uncovered portion can be closed or rolled forward if and when the underlying prices moves toward the money.

The ideal set-up for a variable ratio write is with underlyings with one-point strike differences or, if that isn't available, 2.5 points. For example, with Adobe Systems you could open a variable ratio write by selling two 34 calls and two 35 calls. The 35's were worth 0.73, so your total premium income in this situation is:

  • two 34 calls @ 1.12 = $224
  • two 35 calls @ 0.73 = $146
  • total income = $370

This changes your basis to:

  • Stock $3,356 x 300 = $10,068
  • 4 calls premium income = $370
  • Net basis = $9,698
  • $9,698 ÷ 3 = $3,232.67

This is only slightly less than the straight 4:3 ratio write, but your risk is reduced considerably. If the underlying price moves up above 34 you can close out one of the 35 positions to revert to a straight covered call. You can also wait it out to see if the underlying price will go higher. You can then buy to close or roll forward one or both of the 35 calls. Avoiding exercise is easier, even with a sudden move; and looking at Adobe's recent narrow trading range, that seems unlikely, making this a good candidate for the variable ratio write.

This example includes a two-month holding period. That's a 3.7% return in two months (based on the stock's current market value, so:

  • $370 ÷ $10,068 = 3.7%

Annualized, this comes out to a nice double-digit return. To annualize, first compute yield (I like using the strike for this, so divide the premium by the strike). Next, divide the yield by the holding period in terms of months. Finally, multiply the result by 12. This gives you the return you would get if you kept a position open for exactly one year. It isn't a reflection of all earnings you should expect, but does give you a valid means for comparison between different strikes.

  • ( 3.7% ÷ 2) x 12 = 22.2%

Picking the right company for the ratio write or variable ratio write requires comparisons to maximize the outcome. This can be a simple matter of comparing non-annualized returns for the same expiration. For example, Adobe yielded the following straight outcomes based premium and applicable strike:

  • 34 strike: 1.12 ÷ 34 = 3.3%
  • 35 strike: 0.73 ÷ 35 = 2.1%

Now compare the same two-month strikes for McDonald's (NYSE: MCD), a higher-priced stock but with options expiring at the same time:

  • 97.50 strike 1.83 ÷ 97.50 = 1.9%
  • 100 strike 0.85 ÷ 100 = 0.9%

This demonstrates that regardless of fundamental strength or weakness, similar expiration of options yields vastly different outcomes. In this comparison, you would be better off doing ratio writes or variable ratio writes on Adobe than on McDonald's. The variable ratio write gives you significant control even though part of the position is uncovered. Remember, though, you need the strikes to be greater than your basis, and expiration in two months or less is desirable. But of course, this means you get less premium, right? In dollar terms, yes - but in annualized yield, no. You get more income and a better annualized return writing one-month or two-month covered calls, ratio writes, or variable ratio writes than you will with longer-term expiration.

There are two problems with longer-term expiration: First, this leaves you exposed longer, meaning a greater chance of exercise. Second, return is not as great. Check it out. Compare six two-month covered calls in a year, versus one 12-month position. The shorter the term to expiration, the greater your annualized yield. This is because time decay is at its fastest in the two-month window.

I consider the variable ratio write a sensible and conservative expansion of the covered call. Yes, you could suffer a loss if the stock price soars far above both strikes. This is why you want to carefully select the underlying based on price history, volatility, and technicals (i.e. trading range).

Whether you use options or other strategies, you can expand your trading with numerous low-risk ideas and make the whole thing quick and easy. Check the many strategies for trading secrets at this link if you want to expand into options and beyond while keeping risks as low as possible. Options are exceptionally flexible products for swing trading, and they allow traders to control risks while leveraging capital, in a lower-risk method than with shares of stock. I would enjoy hearing from anyone with questions, ideas or other conservative option strategies: thomsett@conservativetrade.com

Posted-In: candlestick confirmationLong Ideas Short Ideas Options Markets Personal Finance Trading Ideas

 

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