The covered call is a favorite strategy among options traders and even with more conservative value investors in some instances. It is a low-risk strategy compared to just owning 100 shares of stock, and it can be a portfolio cash cow.
The main disadvantage to the strategy is potential lost profits if and when the stock's price takes off. For example, if the call's strike is 40 and the stock rises to $55 at expiration, you lose the opportunity for an additional $1,500 in profit when the call is exercised at the strike.
Covered call writers accept this risk in exchange for the annualized double-digit returns they earn. There is a way to increase earnings even more, however. The ratio covered call write involves selling more calls than the covered number of shares held. For example, if you own 300 shares and you sell four calls, you create a four-to-three ratio write.
Is this the combination of three covered and one naked call? Or is it four calls that are 75% covered? Actually, it is both. Why is this still a low-risk strategy even with the naked aspect in that fourth call?
First of all, this strategy works best with calls having two months or less until expiration. During the last two months, time decay is at its most rapid, so the calls will decline in value very quickly, especially if you select calls just out of the money. For example, if your strike is 40 and the stock is at $38 or $39 per share, the entire premium is time value, and this will decline quickly. It will take considerable price movement of the stock above the strike just to get to breakeven. Meanwhile, as a seller, you benefit when the price falls.
The short positions can be held until expiration, rolled forward, or closed at a profit when premium values decline. Because you start out of the money, you have an excellent chance of avoiding exercise altogether.
The risk is further reduced when you enter a ratio covered call write using two strikes, called a variable ratio write. For example, the stock is at $39 and you own 300 shares. You sell four calls, all expiring in six weeks. Two of these are 40 strikes and the other two are 42.50 strikes. If the price moves above the lower 40 strike, the 42.50 positions can be rolled or closed. Risk is minimal because, even when the stock moves in the money on the first two positions, it remains out of the money (and exercise-proof) on the other two, at least for the moment.
Once that happens, it makes sense to roll forward. Either the in-the-money or all four call be easily rolled to higher strike increments and later expiration. The likelihood of these calls becoming worthless and expiring is high. With the four-to-three ratio write, you only need one to expire worthless to cover the remaining positions.
The strategy is a smart one if you want to increase short-term income for very little risk. The fast expiration means you can continually replace expired or closed positions with new ones, moving ahead profitably with less risk than just owning shares of stock.
Michael Thomsett blogs at TheStreet.com, Seeking Alpha, and several other sites. He has been trading options for 35 years and has published books with Palgrave Macmillan, Wiley, FT Press and Amacom, among others. His latest book is Making Money with Option Strategies