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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 8th edition) has sold over 250,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT... More
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• Variable Ratio Write — A Risk-Reducing Method Of Leveraging The Covered Call 0 comments
Jan 26, 2014 9:33 AM

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 stock purchased at \$33 and currently priced at \$35.50, you could write covered calls. Assume the two-month 35 calls are worth 1.82. So a straight covered call with three contracts yields \$546. Even though the calls are in the money (meaning current price is above \$35), 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. 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 gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. You can take part in discussions among members on the site at the Members Forum.

I also offer a twice-monthly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. Join at Newsletter - I look forward to having you as a subscriber. Please also check out my other site, ThomsettStocks.com

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