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The Ratio Write: Risks and Benefits

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Here's how and when to enhance the covered call to maximize income.

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Most covered call writers take comfort in the relative safety of the position. The premium from the call gives you downside protection, discounting your basis in the stock. But the risk is still there, especially if the underlying price declines below your net. For example, if you buy 100 shares at $55 and sell a $57.50 call for 2 ($200), your discounted basis in the stock is $53 ($55 - $2). If the price falls below that level, you will have a net loss.

This isn't more risk than just owning the stock, when the risk occurs any time the price falls below your original basis. It gives you a lower downside risk. For many, the greater risk is lost opportunity. What happens when the stock moves far above the strike? In that case, you lose the gains you would have had by just owning stock. So covered call writers have to be willing to accept the nice returns from writing calls, knowing that on occasion they could have done better.

Beyond the one-to-one covered call (100 shares of stock versus one call), you can also use the ratio write. This is a strategy in which you sell more calls than you have covered. For example, if you buy 300 shares at $55 and sell four $57.50 calls at 2 each, you create a 4:3 ratio write. You can think of this as three covered calls and one uncovered call, or as four calls that are 75% covered.

Either way, the ratio write is not as risky as it might seem at first glance. Because the four short calls are out of the money, time decay will erode their value rapidly in the last two months before expiration (so focus on positions in that 60-day window to keep risks down, and do ratios on out-of-the-money, or OTM, strikes).

Second, avoid opening a ratio write if an ex-dividend date will occur between now and expiration. If the calls go in the money, exercise is possible on or right before ex-dividend date because long call holders will want to earn the dividend. It does not always happen, but there is a higher chance of it. As long as the dividend dollar value is greater than the buyer's basis in the long call, it makes sense to exercise.

Finally, make sure the premium value is worth the added exposure. The ratio write is a great way to increase income above the widely used covered call, but it does expose you to more risk. For many traders, the added risk is worth the income. But evaluate the entire situation before accepting that risk level.

The strategy allows you to maximize income, especially if you time entry into the ratio write when implied volatility is high; that means premium levels will be high, too. But because part of the position is uncovered, it is essential to develop the means for excellent timing for both entry and exit. In the options world, that means tracking volatility. For options traders, the key to timing of trades is as important as picking the right stock and strike. To make this simple and easy, check Volatility Edge for ideas on how to identify the best candidates for ratio writes and other options-based positions.

About the author: Michael C. Thomsett is an author with six options books published, including the best-selling Getting Started in Options (Wiley, over 250,000 copies sold in eight editions), and Options Trading for the Conservative Investor (FT Press, now in its second edition). The author is also the Chief Education Officer of conservativetrade.com -- a website devoted to helping traders pick high-probability options trades in a conservative trading program. Thomsett's website is www.michaelthomsett.com.
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No positions in stocks mentioned.

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