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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT Press); and "Options for... More
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• ##### The variable ratio write -- less risky than it might appear 3 comments
Mar 1, 2012 11:34 AM | about stocks: MRK

Covered call writers are forever trying to find new ways to expand income, but without the accompanying higher risk. The ratio write -- writing more calls than are covered -- does this to a degree, but not enough.

For example, if you own 300 shares of Merck purchased at \$33, you could write covered calls. At the time of writing this (December 5), Merck was at \$35.47 per share. The April 35 calls were worth 1.82. So a straight covered call with three contracts yields \$546. Even though the calls are \$46 in the money, the premium is rich enough to make it work - and anyhow, the example's basis in stock was \$33, so exercise yields a 2-point profit.

A ratio write may involve writing four calls, for example. In that case, call income goes up to \$728. This 4:3 ratio is fairly safe because one or more positions can be closed or rolled forward.

Still, the ratio write contains an element of market risk.

The variable ratio write is the same idea, but involves two strikes. For example, you may write two of the 35 calls and get \$364, as well as two 36 calls, at 1.28 each, and earn another \$256. Total income: \$621.

The advantage in this strategy is that the high-strike calls are out of the money. Time value is going to evaporate and as long as the calls remain out of the money, exercise risk does not apply.

If stock price does rise, you can take several actions: Close one or more of the calls, roll them forward, or cover the exposed contract (by buying 100 more shares or buying an offsetting long call).

The variable ratio write gives you much more flexibility and reduces the market risk considerably, while providing nice income. Incidentally, Merck was chosen because it also pays a handsome 4.74% dividend.

The variable ratio write is one example of how risks can be managed. At first glance, it might seem high-risk, but considering how it is managed by an astute trader, it is not. To find out more about this and similar kinds of trades, check out low-risk strategies

Michael C. Thomsett is an instructor with the New York Institute of Finance, where he teaches five courses. He is also an investing and options and technical analysis author. He wrote the best-selling Getting Starting in Options (Wiley, http://tinyurl.com/22nmkf2), now in its 8th edition. Thomsett's latest book is Trading with Candlesticks. (FT Press)

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• Thomsett
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Author’s reply » Variables, worth taking a look.
1 Mar 2012, 12:09 PM Reply Like
• nullid2002
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Hi Mr. Thomsett,

I noticed you didn't give a framework to decide on how many extra calls you want to write.

I remember roughly that you use the delta in these calculations. Or, do we need to buy the book? : ) Great book(s), btw.
4 Mar 2012, 02:32 PM Reply Like
• Thomsett
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Author’s reply » Hello and thank for the comment. Of course you need to buy the book! (just kidding) - The decision of which ratio to apply relies on risk tolerance as well as ability to adopt positions. The larger the base, the lower the risk, which for me is the real bottom line. For example, a 5:4 (five calls against 400 shares) is far less risky than a 4:3 or a 3:2. I don't believe that volatility tests should be used to determine the ratio, although timing of the entry should be based on the volatility trend and on proximity between strike/price as well as time to expiration. - Michael
5 Mar 2012, 08:47 AM Reply Like

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