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Options: Pitfalls In The Ratio Write

The attraction of the ratio write is the potential for higher premium income. Traders too often convince themselves that exercise is unlikely, and that time decay is likely to outpace intrinsic value as the stock goes higher, even if the calls go in the money.

Here's the thinking: You own shares of an underlying security. You sell to open ATM, OTM or slightly ITM (At, Out of or In The-Money) call positions with one to two months until expiration. A ratio write is defined as a strategy in which you sell more call options than shares will cover. In essence, you would have a small naked call position (check with your brokerage firm to see if you are qualified to do this in your trading account). ATM and OTM option premium is all time value and extrinsic value (implied volatility). The expectation is that this time premium will evaporate very quickly, so even if the underlying price rises, you can close the exposed portion of the ratio and escape a net loss. Or you can roll the exposed positions forward, or forward and up in strike price.

The problem occurs when the underlying price rises so rapidly that you find yourself suddenly exposed to an expensive exercise loss. You have to either close the exposed (naked short) calls at a loss or roll them forward or up to a higher strike price.

When you roll up you are moving your short option position further out of harm's way, so isn't that a great solution?

No, because in this scenario it is highly likely that the one-to-one calls left are going to be exercised, meaning all of your underlying shares will be called away. Then you're left with those rolled uncovered, short calls. Another factor to keep in mind: Any uncovered calls require collateral equal to the full strike value. So if you write calls at 35 strikes, each uncovered option requires $3,500 collateral on deposit.

So much for the low-risk strategy.

A partial solution is found in the variable ratio write. Use two strikes instead of one, and you set up a more effective buffer zone. The lower strike should be ATM or slightly OTM, and the ideal higher strike will be either one point or 2.5 points higher. Use one- to two-month expirations to maximize time decay.

Here's an example of a variable write. You own 600 shares of stock at $40. You would be satisfied with losing some or all of the shares if they were assigned. Sell 4 of the 45-day 40 strike calls and sell 4 of the 45-day 42.50 calls. The credit received is all time value premium, and the 40 strike calls being ATM have the most time value premium. Two of the calls are uncovered. If the underlying begins moving towards 42.50, you can close the higher strike calls, perhaps at a profit (depending on time until expiration and time decay), and avoid the unpleasant prospects of big losses due to the shares moving even higher or an uncovered exercise. Or, you could roll the 42.50 calls to the 45 strike calls with the same expiration or a later expiration.

The variable expansion of the ratio write reduces risks significantly; but it does not eliminate them. You have to be willing to live with the risk of a sudden, significant movement in the underlying. And if you do end up having to roll out of exercise danger, you may want to consider rolling the higher strike calls to a later-expiring variable write (rolling the 45-day 42.50 calls to the 75-day 45 strike calls - rolling up and out). This at least defers exercise while generating more income. Hopefully, you can wait for time decay to make your roll profitable. But as an options trader, that one word -- hopefully -- too often is the downfall of a strategy that looked good on paper.

Don't overlook the collateral requirements for uncovered options. To read more about this, download the free report at CBOE Margin Manual

The variable ratio write looks like a great strategy, and it is easy to overlook the risks it involves, not to mention the collateral requirement equal to 100% of the strike value. By the way, if you roll uncovered short calls to a higher strike, your collateral requirement goes up, too.

Michael Thomsett blogs at the CBOE Options Hub and several other sites. He is author of 11 options books and has been trading options for 35 years. Thomsett Publishing Website