What Is Ratio Call Write?
- A ratio call write is an options strategy.
- Traders who own shares in an underlying stock sell more call options than the total number of shares owned in a ratio call write.
- Traders who execute these transactions aim to capture the additional premiums received by the option sales.
- Call writers hope that there is little to no volatility at all in the underlying stock over the same period.
- The potential for profits is capped and losses become infinite with ratio call writes.
Understanding Ratio Call Write
The goal of a ratio call write is to capture the additional premiums received by the option sales. The call writer hopes that there is little to no volatility at all in the underlying stock over the same period. The tradeoff with these kinds of transactions is that the potential for profits is capped and, since these are call options, they come with the possibility of unlimited risk.
Options are derivative contracts that give an investor the right to buy or sell securities at a given price. These contracts are divided into two different branches: call and put options. Call options allow buyers to purchase the right to buy the underlying asset at a set price in the future while a put option allows the buyer to sell the underlying asset at a set price in the future.
Traders have many options strategies available to them, including ratio call writing. With call writing, traders sell call options in order to gain premiums. In ratio call writing, the ratio represents the number of options sold for every 100 shares owned in the underlying stock. For example, a 3:1 ratio call write implies writing three call option contracts (representing a total of 300 shares) while owning one hundred shares of the asset.
The payoff from holding the asset and writing the calls resembles a traditional covered call, except the potential profit is amplified. At the same time, the potential loss becomes infinite, since the investor essentially has a 1:1 covered call position and then is short two more naked calls. These naked shorts have an unlimited loss potential as the price of a stock can, in theory, go to infinity.
The profit range for ratio call writes is often very narrow, hence why they're capped. A large drop in price may end up costing the trader a considerable sum of money in the shares they own that exceeds the amount of premium collected. If the price of the underlying shares increases too much, the trader will also lose.
A ratio call write falls under the broader category of options strategies known as buy-writes.
As we mentioned above, ratio call writing is similar to a covered call. Remember that a covered call is a strategy whereby the owner of the underlying asset sells call options at an equal or higher strike price to where the stock is currently trading in a 1:1 manner. The purpose of the covered call strategy is to generate extra income from the premiums collected from the sale of the option.
The strategy pays off most when the stock doesn't change from its current level since the call will eventually expire worthlessly and the investor will still own the shares while collecting the entire options premium. But writing covered calls limits the upside potential since the short calls will be assigned and any gains in the stock above the strike price will be offset by the short call.
Ratio Call Write Example
Here's a hypothetical example to show how ratio call writing works. Let's say shares of Company XYZ trade at $50 per share. An investor who owns 1,000 shares in the company may sell 10x of the 60 strike call option expiring in three months. This would be a covered call. In a ratio call write, they would instead sell more than 10x, say 25x, of the 60 strike call.
As long as XYZ stock remains below $60, the investor will remain profitable. That's because the call options will expire worthless and the investor will collect the entire premium of the 25 options that were sold. If, however, XYZ's stock price rises substantially above $60, the investor will lose money since the long stock position is not fully hedged against the larger amount of short calls that become in-the-money (ITM).