Options Trading Made Easy: Covered Ratio Spread

Options Options Trading
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Adding to our list of ratio write trades that include stock ownership is the “covered ratio spread,” a strategy that’s initiated when little volatility is anticipated and a trader wants to generate cash against an open stock position.covered ratio spread
This is a fairly safe strategy that maximizes gains should the stock rise slightly before expiration.
How is it built?
A covered ratio spread is a multi-legged operation that consists of

  1. Ownership of the underlying stock;
  2. The sale of two out-of-the-money call options; and
  3. The purchase of one further out-of-the-money option.

Keen traders will see that this is essentially a covered call overlaid with an additional bear call spread. With that in mind, the trade’s risk/reward parameters become clearer. A look at a real trading example will help to uncover all the details.
Below is a chart of Goodyear Tire & Rubber Co. (NYSE: GT) directly after the stock shot significantly higher:
Goodyear covered ratio spread
You own Goodyear stock and are happy with the latest burst higher. But your research and experience tell you it’s going to take some time to digest the gains, and the stock is likely to meander in the months to come.
Not happy sitting on a nonproductive asset, but equally unhappy losing out on the hefty and reliable dividend, you seek a different avenue for action.
Your broker suggests a covered ratio spread, and in late February, with the stock sitting at exactly $26.50, you decide to act (red circle). You sell two July 27.50 calls for $3 each and buy one July 28.50 call for $1. Your total credit on the trade is $5.

Risk/Reward Breakdown

As it turns out, the stock does indeed meander, closing on the third Friday of July at precisely $27.50 (blue circle).
At that point, your profit is $600, including a $1 gain on the shares and $5 from the initial credit ([$1 + $5] x 100). That’s the maximum possible profit for the trade: when the stock settles at the short call strike and all options expire worthless.
But what would have happened if the stock became volatile and, say, dropped significantly?
Your break-even point on a covered ratio spread occurs when the loss on the stock overtakes the value of the initial credit.  In this case, that point comes at $22.50 ($27.50 – $5), and that’s a reasonable cushion for a trader expecting little volatility going forward.  Should the stock continue to fall beyond that level, however, the losses would be theoretically unlimited.
What if the stock shoots higher?
On the upside, things are balanced. Remember, this is a covered position. If the underlying moves to $28.50 by expiry, the long call expires worthless and the two short calls are $1 in the money. That’s a $200 gain in the price of the stock, less a $200 loss from the short puts (net zero), leaving the trader with his initial $500 premium.  Beyond $28.50 – no matter how far the stock carries – gains are capped at $500.
Trader’s Note: A covered ratio spread is an excellent means of augmenting a covered call strategy with additional premiums.

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