The ratio call write is a neutral strategy in options trading in which the options trader owns a holding of the underlying stock and sells more calls than shares owned. It is a limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the underlying stock price will experience little volatility in the near term.
|Ratio Call Write Construction|
|Long 100 Shares|
Sell 2 ATM Calls
A 2:1 call ratio write can be implemented by selling 2 at-the-money calls for every 100 shares owned.
Maximum profit for the ratio call write is limited and is made when the underlying stock price at expiration is at the strike price of the options sold. At this price, both the written calls expire worthless while the value of the long stock position remains unchanged. As such, the options trader gets to keep all of the premiums received when putting on the trade. Thus, maximum profit is equal to the premiums received from the sale of call options.
The formula for calculating maximum profit is given below:
Loss occurs when the stock price makes a strong move to the upside or downside beyond the upper and lower breakeven points. There is no limit to the maximum possible loss for the ratio call write.
The formula for calculating loss is given below:
There are 2 break-even points for the ratio call write position. The breakeven points can be calculated using the following formulae.
Using the graph shown above, since the maximum profit is $400, points of maximum profit is therefore equals to 4. Therefore, upper breakeven is at $49 while lower breakeven is at $41.
Suppose XYZ stock is trading at $45 in June. An options trader executes a 2:1 ratio call write strategy by buying 100 shares of XYZ stock for $4500 and selling two at-the-money JUL 45 calls for $200 each for a total of $400.
On expiration in July, if XYZ stock is still trading at $45, both the JUL 45 calls expire worthless while the long stock position is still worth $4500. At this point, the options trader is positive $400 in the money because of the premiums earned. He can then choose to enter another ratio write or sell the shares and take profit.
If XYZ stock rallies and is trading at $49 on expiration in July, all the call options will expire in the money. The two written JUL 45 call are now worth $400 each. This $800 loss is completely offset by the $400 appreciation of his long stock position and the $400 in premiums he received earlier. Therefore, he achieves breakeven at $49.
Beyond $49 though, there will be no limit to the loss possible. For example, at $60, each written JUL 45 call will be worth $1500, resulting in a combined loss of $3000 on the short position. Meanwhile, his long stock position has only appreciated by $1500 and together with the $400 in premium received, the options trader still need to come up with another $1100 to close the position.
Using the formula for computing the breakeven point, we calculated the lower breakeven point to be $41. At $41, all the call options expire worthless. However, his long stock position also suffers a loss of $400 in value but this loss is offset by the $400 in premiums earned. Therefore, there is breakeven at $41.
Below $41 however, there is no limit to the potential loss. For example, if the stock price is trading at $30 on expiration, while all the call options expire worthless, the long stock position suffers a $1500 drop in value. Even with the $400 in premiums to offset the loss, the options trader still suffers a $1100 loss.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
The following strategies are similar to the ratio call write in that they are also low volatility strategies that have limited profit potential and unlimited risk.
When the underlying stock price is between two strike prices and at-the-money calls cannot be written, the variable ratio write can be used instead.
A similar ratio write strategy that is constructed using puts and short stock instead is known as the ratio put write. It has the same profit potential as the ratio call write but it is an inherently inferior strategy.
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