The variable ratio write strategy is a relatively safe way of trading a stock that one expects will experience little volatility in the near future.
It’s closely related to other ratio write strategies that combine stock ownership with the sale of more call options than shares owned. But there’s one essential difference.
Whereas a simple 2-to-1 ratio write strategy might involve the sale of two at-the-money calls against the underlying stock, the variable ratio write strategy entails the sale of one in-the-money and one out-of-the-money call. The resulting profit/loss profile is thereby diminished, with the variable ratio write trader affording himself less profit potential – but, at the same time, buying wider price range from which to profit.
To the charts!
Let’s move directly to a real-world example in order to flesh out all the details of the trade, including its break-even points and maximum profit and loss parameters.
This is a chart of consumer food giant General Mills (NYSE: GIS) during a particularly slow trading period:
Imagine it’s late July, you own the stock, and the shares have been meandering for some time now. Because the move to this level was a quick one, you expect the sideways drift to continue for a little longer. But you’re not prepared just to sit on dead money. You ask your broker what can be done to generate some additional cash.
He tells you about variable ratio writing, and you’re intrigued. With the stock at $57 you decide to put one on. You sell one in-the-money November $53 call for $7 and one out-of-the-money $60 call for $2, for a total credit of $9.
Time Is Money
The stock performs exactly as you expected and does precisely nothing. It closes the third Thursday of November at $57 even (blue circle), and you make off like a bandit.
Your short $60 call expires worthless and your short in-the-money $53 call is worth $400. You buy it back at expiry and are left with a hefty $500 profit ($900 – $400).
That $500, by the way, is the maximum profit the trade can earn. So long as the underlying expires between the strikes selected, that profit is yours.
With two separate strikes, the trade will also have two distinct break-even points. On the downside, it occurs when losses on the stock position erode the full value of the initial premium taken in. In this case, that point arrives at $48 ($57 – $9). Any move below $48 results in a theoretically unlimited loss for the trade.
On the upside, break-even occurs when losses on the two short calls overtake the gains from the long stock position combined with the initial premium garnered. In the above example, that level arrives at $65. At that point, the stock is up $800 and the premium earned is $900, for a total profit of $1,700.
At the same time, the short $53 call is in the money $12 and the $60 call is in the money an additional $5, for an offsetting loss of $1,700. Of course, beyond $65 your losses are theoretically unlimited.
Monitor your trades!
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