Introduction To Ratio Call Write Option Strategy
As its name suggest, the ratio call write is constructed with call options and ownership in the underlying security. To be more specific, the ratio call write is an option trading strategy that involves the purchase of the underlying security and the simultaneous short sale of call options on the very same underlying security. By doing so, the strategy capitalises on little to no volatility in the underlying security. As a consequence of a ratio call write, profit potential is capped and there is an unlimited risk.
Net credit
The ratio call write options strategy results in a net credit, that is, a net premium is collected from the short sale of call options.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Expectation Of Low Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Unlimited loss potential
Step 7 : Capped profit potential
Step 8 : Calculating the maximum profit for a ratio call write
Step 9 : Calculate Risk & Reward Ratio
Step 10 : Executing the ratio call write
Step 11 : Exit Trade
Step 12 : Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
Low volatility conditions are vital to the success of a ratio call write strategy. The trader should scan upcoming events related to the economy or the underlying security that may cause volatility levels to increase. If these events are absent, the conditions to execute a ratio call write are optimal. Some of the chart patterns an options trader should look out for are:
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 : Outlook – Expectation Of Low Volatility
The ratio call write is an inverted V shaped risk and reward profile. That means that for the strategy to yield the greatest profit, there must be little anticipated volatility in the underlying security over the life of the call options shorted. From the risk and reward profile, it is evident that the maximum profit is only experienced at one price point in the underlying security.
Step 3 :Study the option chain
Examine the options chain. Select the options for the construction of the ratio call write. After this has been done, breakeven analysis can be performed.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
The calculation of the upside and downside breakeven points is shown in the formulas below.
Upside breakeven point = Exercise(Strike) price of calls + Net credit received
Downside breakeven point = Exercise(Strike) price of calls – Net credit received
Step 5: Understand Your Profit Zones
After calculating the breakeven points, the trader must understand that the profit zones for a ratio call write is between the breakeven points.
Step 6 : Unlimited loss potential
Due to the inverted V shaped risk and reward curve, there is unlimited risk to the upside. To the downside however, there is limited risk.
The ratio call write experiences a paper loss if the price of the underlying security is trading at levels above the upside breakeven point or at levels below the downside breakeven point.
Step 7 : Capped profit potential
The profit potential of a ratio call write is capped. That means that there is a limit to the amount of potential profit. Furthermore, the maximum profit is realisable at only 1 price point in the underlying and not over a range or price points. This is one consideration to take note of before placing a ratio call write trade.
Step 8 : Calculating the maximum profit for a ratio call write
The maximum profit of a ratio call write can be calculated as:
Net credit received – brokerage fees paid
Step 9 : Calculate Risk & Reward Ratio
With the appropriate stop losses in place, calculate the potential risk reward ratio.
Ensure that the trade is attractive relative to other trades on a risk reward basis.
Step 10 : Executing the ratio call write
For every 100 shares purchased, the trader should simultaneously write 2 at-the-money call options. The premium collected from the short calls is the net credit received.
Step 11 : Exit Trade
Exit the trade when a profit can be realised. Also, exit a trade if the trade is in unprofitable territory and there is little chance of the underlying security trading between the breakeven points.
Step 12 : Record Trade In Diary
After the trade has been exited, record the trade in a diary for analysis, comparison and reflection. By doing so, a trader should be able to identify his weaknesses and work on his strengths, and become a better trader over time.
Example Of A Ratio Call Write
XYZ Corp is trading at a price of $50. The current month calls are selling for $2.50 each. An options trader decides to execute a ratio call write trade by purchasing 100 shares of XYZ Corp and selling 2 at-the-money current month call options as he predicts the volatility to be low over the life of the call options.
For that, he collects a net credit of:
$2.50 x 100 x 2 = $500
The upside breakeven point is:
$50 + $5 = $55
The downside breakeven point is $50 – $5 = $45
When the price of XYZ trades above the upside or below the downside, the trade is in loss territory. If it is liquidated at that point in time, a loss will be incurred.
Let us examine the scenario where the price of the underlying security, XYX, trades at $50 on the expiration of the options.
| Beginning value | End value | Profit(+) or Loss(-) | |
| Long 100 shares | $50 | $50 | No profit or loss |
| Short 2 ATM calls | $2.50 each | $0 | + $2.50 each |
At $50, the options expire worthless. If the ratio call write is closed out totally at $50, the profit would thus be:
$2.50 x 2 x 100 = $500
$500 is also the net credit and the maximum profit that the strategy can earn. That is also the reason the trader should try to maximise the net credit received by selling when volatility is high, going into a period of low impending volatility.
Comparable strategies
The ratio put write is a strategy that is very similar to the ratio call write. Both strategies have an inverted V shape risk and reward profile and capitalise on low volatility conditions in the underlying instrument.