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Options Trading: Four Techniques to Reduce Risk in Covered Call Ratio Writing

By  Oct 14, 2010

Topics: Finance & Investing

The “ratio write” is a variation of the well-known covered call. It increases market risk but, properly put together, those risks are manageable for moderate investors and -- in some formations -- even for conservatives. If you like the covered call, you might also like the ratio write.

You enter into a ratio write when you sell more calls than the one option to 100 share fully covered relationship. A covered call is safe because in the worst-case outcome (exercise) you relinquish 100 shares at a profit in addition to keeping the option premium. In a ratio write, you sell more calls than you can cover, earning more premium income. For example, if you own 300 shares and you sell four calls, you set up a 4-to-3 ratio write. You can look at this as four short calls that are all 75% covered, or as three covered calls and one uncovered call.

The best time to enter into a ratio write is when the option’s implied volatility is high. At such times, premium is richer than it should be, meaning that when volatility settles down, the calls can be closed at a profit.

There are three techniques for reducing the risk in ratio writing. These are:

1. Write higher long calls to offset the uncovered portion. You can virtually eliminate the added market risk of the uncovered portion, by buying higher-strike long calls. This works best in flexible strike scenarios, such as strikes at every point of 2.5 points rather than on stocks with 5-point strike increments. You have to make sure the numbers work out. The cost of the long position takes away part of the profit in the short positions, and using the long to satisfy assignment would also involve the distance between the short strike and the long strike. The lost likely way to set up this protective cover is by adding the depreciated long later than the date when the original ratio write was opened.

2. Avoid exercise with the forward roll. You can close out a current short call and replace it with one expiring later. In this way, you avoid exercise, which usually takes place close to expiration. (Remember, though, exercise can happen at any time the call is in the money. This idea is not a guarantee, only a strategy for avoiding most exercise while earning more call premium income.

3. Enter into a variable ratio write. You can also reduce risk by employing more than one strike. For example, if the stock is now worth $29 per share and you own 300 shares, a variable ratio write could consist of two calls at a 30 strike and two at a 32.50 strike. If the stock price rises, you can roll positions forward to avoid exercise; you can go long a higher call to cover the short calls; or you can take advantage of rapidly declining time value to close out a portion of the ratio write, reverting to the basic covered call.

4. Pick calls due to expire in approximately six weeks, that are close to the money. The best candidates for a ratio write are calls that expire in the cycle following the current month. Most time decay takes place in the last four to six weeks of the option’s life. Most implied volatility moves in options closest to the money. These two factors, combined, define the best calls for the covered call ratio write -- meaning those most likely to lose value rapidly. Because it is a short position, high implied volatility and fast time decay are great advantages.

Michael C. Thomsett is an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks.