Variable Ratio Writes : Earn Premium With Little Volatility

Introduction To Variable Ratio Writes

Variable Ratio Writes

The variable ratio write is a strategy that has a limited potential profit and potentially unlimited losses with large fluctuations in the price of the underlying security. Hence, a trader that executes a variable put write anticipates low price volatility of the underlying security. When that happens, the variable ratio write stands a higher chance of earning a maximum profit because there us a fairly large price range where maximum profit can be earned. In essence, the variable put write involves:

  • Ownership of the underlying security
  • Writing out of the money calls against that ownership
  • Writing in the money calls simultaneously

An example of a variable ratio write is to long 100 shares of the underlying security, short 1 out of the money call and 1 in the money call. All the options involved are derived from the same underlying security and have the same expiration dates. However, the call options have different strike prices.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Little Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis & Breakeven point(s)
Step 5: Understand Your Profit Zones
Step 6 : Potential for unlimited losses
Step 7 : Calculating the loss of a variable ratio write trade
Step 8 : Limited profit
Step 9 : Calculation of maximum profit
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade – Executing a variable ratio write options trading strategy
Step 12 : Exit Trade & Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

Before execution of the variable ratio write, the options trader should perform economic, fundamental and technical analysis. Some of the suggested chart patterns the options trader should look out for are:

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 :Outlook – Little Volatility

The trader that executes a variable ratio write is expecting little volatility in the price of the underlying security. He may deem that there are no upcoming earnings announcements, no major positive or negative news, no analyst re-ratings of the company etc, hence, little volatility is to be expected of the underlying security. Even better, if the price of the underlying security stays constant till expiration, he will certainly earn the maximum profit.

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Step 3 :Study the option chain

Examine the options chain and start selecting the options to be used in the construction of the variable ratio write. Also be mindful of the current trading price of the underlying security since a variable ratio write requires the ownership of the underlying security.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis & Breakeven point(s)

There are 2 breakeven points in a variable ratio write strategy. There is an upside breakeven point and a downside breakeven point. These are price points at which there is neither profit nor loss. For example, if the upside breakeven point if $5, when the price of the underlying security is at this price, there is no profit nor loss.

The upside breakeven point is a greater value than that of the downside breakeven point. For that reason, it is aptly named the “upside breakeven point”.

The upside breakeven point can be calculated as:

Highest strike price + maximum profit per share

There are call options at different strike prices when  a variable ratio write is executed. To calculated the upside breakeven point, take the strike price that is the highest and add the maximum profit per share. If the maximum possible profit from the variable ratio write is $500, then the maximum profit per share is $5. Next, add $5 to the highest strike price to get the upside breakeven point.

The downside breakeven point can be calculated as:

Lowest strike price – maximum profit per share

When the price of the underlying security is less than the upside breakeven point and greater than the downside breakeven point, the variable ratio write will turn a profit.

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Step 5: Understand Your Profit Zones

Variable Ratio Writes

After calculating the breakeven points, the options trader will understand where the profit zone is. Hence, step 4 is a very important step. Once the trader knows where the breakeven points are, the trader should be mindful that profit can only be attained when the price of the underlying security trades between the breakeven points.

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Step 6 : Potential for unlimited losses

A loss on the variable ratio write trade occurs when:

  • the price of the underlying security moves below the downside breakeven price point

or

  • the price of the underlying security moves above the upside breakeven point

The price of the underlying security can theoretically go up to infinity and could possibly trade all the way down to 0 within the life of the options. Hence, there is a potential for unlimited losses in a variable ratio write trade.

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Step 7 : Calculating the loss of a variable ratio write trade

The loss of a variable ratio write trade is dependent on the price of the underlying security. If the price of the underlying security has moved up beyond the upside breakeven point, the loss can be calculated as:

Price of underlying security – strike price of call – ( lower strike price – acquisition price of underlying security – commissions paid to broker + net credit received)

If the price of the underlying security moves below the downside breakeven point, the loss can be calculated as:

Lower strike price of call – price of underlying security – ( lower strike price – acquisition price of underlying security – commissions paid to broker + net credit received)

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Step 8 : Limited profit

Due to the way that the variable put write is structured, it is a limited profit strategy. The maximum profit is realizable only when the price of the underlying security trades between the strike prices of the calls and the puts where the put has a lower strike price than the call. A good way to think about the maximum profit potential is this. When the price of the underlying security is constant till expiration, there is no loss on the long stock position. The call and the put expires worthless. When this happens, the profit is limited to options premium collected when shorting the options. The maximum profit is thus earned from the time value of the options. Within a certain price range that the underlying security trades at, the options will expire worthless and hence, the trader earns the maximum profit.

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Step 9 : Calculation of maximum profit

The maximum profit calculation is:

Total premiums collected from writing calls – acquisition price of the underlying security + lowest strike price – commissions paid to broker

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Step 10 : Calculate Risk & Reward Ratio

Since there is a potential for unlimited losses and maximum profit is limited, it would be wise to put stop losses in place. Next the trader should calculate the  risk reward ratio. Is the reward worth the risk? Compare the risk and reward ratio of this trade to others. This may or may not be the trade for you based on the projected risk and reward ratio.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade – Executing a variable ratio write options trading strategy

A trader that executes a variable ratio write strategy will:

  • Buy 100 shares
  • Short 1 lower strike in the money call
  • Short 1 higher strike out of the money call

Keeping to the ratio above constitutes a variable ratio write strategy.

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Step 12 : Exit Trade & Record Trade In Diary

After the trade has been exited, the trader should record the trade’s performance in a diary or a journal for reflection and analysis. Over time, this will help the trader to sharpen his skills.

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Example Of A Variable Ratio Write

ASD Corp is trading at a price of $65. A trader feels that the price of ASD will fluctuate between $63 and $68.He decides to place a variable ratio write trade by:

  • buying 100 shares at a price of $65
  • writing 1 December 60 call at a price of $8
  • writing 1 December 70 call at a price of $1

The total options premiums collected from the trade is thus:

($8 + $1) x 100 = $900

In general, the greater the premiums collected from writing the calls, the greater the maximum profit attainable. Hence, it is very important for a trader to get the maximum price possible when writing the options. Please refer to the maximum profit calculation above.

If the price of ASD trades at $65 on expiration:

Beginning value End value Profit(+)or Loss(-)
Long 100 shares $65 $65 $0
Short 1 December 60 call $8 $5 +$3
Short 1 December 70 call $1 $0 +$1
Overall profit per share +$4

The overall profit is thus:

$4 x 100 = $400

This is also the maximum profit attainable.

The maximum profit can also be calculated as:

($9 – $65 + $60) x 100 = $400

Please refer to the formula above. If you’d like to take into account the commissions paid to the broker, you would have the subtract commissions paid from the above.

The upside breakeven point is :

$70 + $4 = $74

The downside breakeven point is:

$60 – $4 = $56

If the price of the underlying security trades anywhere between $56 and $74, the variable ratio write will turn a profit. If the price of the underlying security trades between the strike price of $60 and $70, the variable ratio write trade will earn the maximum profit.

Let us look at another example when the price of ASD trades beyond the range of $56 to $74. if the price of ASD trades at $90:

Beginning value End value Profit(+)or Loss(-)
Long 100 shares $65 $90 +$25
Short 1 December 60 call $8 $30 -$22
Short 1 December 70 call $1 $20 -$19
Overall profit per share -$16

When the above happens, the total loss is:

$16 x 100 = $1600

The greater the swing in price above and below the breakeven price points, the greater the losses. Hence, the potential for losses is unlimited for the variable ratio write strategy.

Short guts, short strangle and variable ratio write

The  short strangle and variable ratio write are options trading strategies with very similar risk profiles. The three strategies are similar in a sense that there is a range of underlying security prices at which maximum profit is earned. However, the way in which the trades are structured are different.

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