A Variable Ratio Write is an advanced options investing strategy that involves holding a long position in an underlying asset while writing multiple call options at various strike prices. Essentially a more complex form of the buy-write strategy, this technique offers a supplementary stream of income generated from the premiums paid for these call options. This strategy is particularly effective on stocks with little expected near-term volatility.
Key Takeaways
- A Variable Ratio Write strategy is designed for traders looking for an additional source of income from a stock they already own.
- This approach is ideal when the stock is expected to remain relatively stable for a period of time.
- The strategy involves selling multiple call options at different strike prices.
- The main potential for profit comes from the premiums collected from these call options.
Understanding Variable Ratio Writes
In ratio call writing, the term “ratio” refers to the number of options sold for every 100 shares of the underlying stock owned by the trader.
For example, in a 2:1 variable ratio write, a trader might hold 100 shares of the underlying stock and sell 200 call options. Two types of calls are typically written: one “out of the money” (where the strike price is higher than the current stock price), and another “in the money” (where the strike price is lower).
The payoff of a Variable Ratio Write is similar to that of a reverse strangle. A strangle strategy typically involves buying both a call and a put on the same asset. A successful variable ratio write offers limited profit potential but comes with significant, albeit manageable, risk.
When to Use a Variable Ratio Write
When deploying a Variable Ratio Write strategy, timing and market conditions are critical. The strategy should be approached with caution by inexperienced traders due to its unlimited risk potential. Losses can mount if the stock’s price moves significantly in either direction beyond the breakeven points established by the trader.
Despite these risks, the variable ratio write can provide flexibility and managed market risk for seasoned investors. Here’s how you determine the two breakeven points:
Upper Breakeven Point = SPH + PMP
Lower Breakeven Point = SPL − PMP
Where:
SPH = Strike price of the higher strike short call
PMP = Points of maximum profit
SPL = Strike price of the lower strike short call
Real-World Example of a Variable Ratio Write
Consider an investor who holds 1,000 shares of company XYZ, currently trading at $100 per share. The investor believes that the stock won’t fluctuate much over the next two months.
The investor then decides to create a Variable Ratio Write position by selling 30 calls with an 110 strike price, which will expire in two months. The premium for these 110 strike calls is $0.25, resulting in a total collection of $750 in premiums from selling the options.
If, after two months, XYZ shares remain below $110, the investor will keep the entire $750 premium as profit, because the calls will expire worthless. However, if the shares exceed the breakeven price of $110.25, gains from the long stock position will be offset by losses from the short calls. Since the options represent 3,000 shares of XYZ, three times the amount owned by the investor, careful management of this strategy is essential.
Related Terms: strike prices, buy-write, out of the money, in the money, reverse strangle, breakeven points.
References
- The Options Guide. “Variable Ratio Write”.
