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Options trading: The Protected Covered Call Ratio

By  Oct 21, 2010

Topics: Finance & Investing

The ratio write consists of writing a combination of covered and uncovered calls. The uncovered portion is at risk, but the strategy is not as high-risk as just writing uncovered calls. The combination of time decay and implied volatility makes a well-timed ratio write a safe strategy, assuming all of the right elements are in place. For those seeking more protection than what is provided by time decay, you can protected the uncovered portion with a higher-strike long call.

A potential problem with the long call cover is that it reduces your net credit from the ratio write. Given the limited protection it provides, would it be more profitable (and less complicated) to just write a covered call?

The protected ratio write is more profitable than a simple covered call. An illustration: At the close of trading on September 9, 2010, Caterpillar (CAT) closed at $70.64 per share (this is the price used to calculate returns in the following). The October 72.50 calls were worth 2.14 ($214) each and the October 75 calls were worth 1.17 ($117).

A covered call with the 72.50 calls produces a yield of about 3% (2.14/70.74), and if you assume this is a one-month return, the annualized return is 36% (3% x 12 months).

In comparison, a protected ratio write consists of writing four calls and then buying one higher-strike call at the same time: If you own 300 shares of Caterpillar, the September 9, 2010 value of those shares is $21,192 ($7,064 x 3). You can write four calls at the 72.50 strike and buy one call at the 75 strike (all with October expiration):

            Three short 72.50 calls @ 2.14 = $8.56

            Less one long 75 call, 1.17 = $1.17

            Net credit = $739, or 3.5% return in one month (42.0% annualized).

In this example, the ratio write has no net exercise risk. In the event of exercise three of the four calls are covered by stock and the fourth call is covered by the 75 call. In the event of exercise, the loss on that position is $250 (the net difference between the long 75 strike and the short 72.50 strike). This would reduce the profit on the call transactions to $489 ($739 - $250), or 2.3% (annualized return of 27.6%).

Even this worst-case outcome is unlikely. Given the rapid time decay you will experience during the one month until expiration, these out-of-the-money short positions are likely to lose value quickly. Even if the stock price moves above the 72.50 strike, one or more of the short positions can be rolled forward to avoid exercise (or even rolled forward and up one strike to convert the in-the-money positions to out-of-the-money positions).

There are numerous ways to either avoid exercise or to eliminate all risk of a net loss with the protected ratio write. The need to avoid exercise is not a likely event, either, given the fast time decay that is going to occur in the one month to expiration.

Opening a protected ratio write is more complex than the straightforward covered call. However, in this example it produced additional yield of 6% (annualized) over the covered call (42% versus 36%) while eliminating all risk of short call exercise. This expansion of covered call writing makes the popular strategy more popular, more challenging, and best of all, more profitable.

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.