What Is a Ratio Call Write?
A ratio call write is an option strategy similar to a covered call, but where an investor owns shares in the underlying stock and then sells (writes) more call options than the amount of underlying shares owned. 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 volatility in the underlying stock over the same period.
A ratio call write falls under the broader category of options strategies known as buy-writes.
- A ratio call write involves selling upside call options while being long the underlying asset, but in a ratio where the calls exceed the long position.
- A ratio call write is essentially a covered call with additional short calls.
- The strategy maximizes payoff if the underlying asset's price is just under the calls strike price at expiration, but provides unlimited loss potential if the underlying asset rallies through the strike price.
How Ratio Call Writes Work
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 is to generate extra income from the premiums collected from the sale of the option. The strategy pays off most when the stock does not change from its current level, since the call will eventually expire worthless and the investor will still own the shares while collecting the entire options premium. However, 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.
In ratio call writing, the ratio represents the amount 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) and being long 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 calls naked. These naked shorts have an unlimited loss if the price of the stock goes up and up.
Thus, the profit range for ratio call writes is often very narrow. A large drop in price may end up costing the trader a considerable sum of money in the shares that exceeds the amount of premium collected. If the price of the underlying shares increases too much, the trader will also lose, as explained above.
Example of a Ratio Call Write
For example, if an investor has 1,000 shares of XYZ, which is trading at $50, he may sell 10x of the 60 strike call option expiring in 3 months. This would be a covered call. In a ratio call write, he or she would sell more than 10x, say 25x, of the 60 strike call.
As long as XYZ stock remains below $60, the investor will remain profitable, since the call options will expire worthless and they will collect the entire premium of the 25 options that were sold. If, however, the price of XYZ stock 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 which become in-the-money.