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Twitter As we’ll shortly see, ratio writing strategies are multi-directional and can even be written to include the sale or purchase of the underlying stock. And while each trade offers its own profit/loss profile and is geared toward a different market reality, the success or failure of the initiative always resides with the trader.
Options trading is not a science, and at times it’s far more art. As with all complex endeavors, experience and good guidance are fundamental to consistent winnings.
Adding to an Existing Long Position
That said, let’s look at a strategy that combines ratio writing principles with ownership of the underlying stock. It’s called a ratio call write and it consists of:
- Ownership of 100 shares of the underlying stock; and
- The sale of two or more at-the-money call options (any number representing more stock than you own).
The ratio call write strategy is initiated when a trader already owns the stock or wishes to acquire the benefits of stock ownership – such as dividends, voting rights, etc. – but at the same time expects there to be little to no volatility of the stock before expiry.
It’s also best suited to a trader with a slightly downward bias for the stock.
Let’s examine a real-life trading example to better understand the strategy.
This is a chart of retailer Macy’s (NYSE: M) during a relatively slow period for the stock:
Let’s imagine you own 100 shares of Macy’s and watch it rise convincingly through February and March before deciding the move is done. You expect some sideways action for the coming months as traders digest the latest gains, but you’d prefer not to sell, as the yield on the stock is still slightly better than 4%. At the same time, you hate the thought of just sitting on “dead money.”
After consulting with your broker, you initiate a ratio call write. With the stock at $58, you sell two at-the-money July 58 calls for $3 each and pocket $600 (red circle).
A Slow Perfect Meander
As it turns out, you were right. For the next three months, the stock trades within a tight range (between $55 and $60) and closes the third Friday of July at exactly $57 (blue circle). Your at-the-money calls expire worthless and you come away with some nice scratch for your efforts.
How much?
Well, you lost $100 on the shares with the $1 decline, but the $600 you gained – along with a roughly 4% dividend garnered from the same period – puts you nearly $750 in the black.
And that beats sitting around doing nothing!
Potential Losses
Every ratio call write will have a different profit/loss profile depending on the number of calls written and the strikes selected. But there will always be two distinct break-even points (seen above, in green).
In this example, the downside break-even is the point at which the stock’s losses chew up the initial premium, or $52 ($58 – $6). After that, the downside is unlimited.
On the upside, the potential loss is similarly unlimited, and the break-even arrives when capital gains in the stock coupled with the initial premium are overtaken by losses in the two short call positions. In this case, those losses begin at $64 ($600 stock gain + $600 premium – $1,200 loss on two short calls).
Trading Notes: Losses can mount very quickly if the stock becomes volatile – particularly to the upside. Monitor your trades, and be ready to close them out before a worst-case scenario develops.
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