What Is a Variable Ratio Write?
Let me explain what a variable ratio write is—it's a strategy in options investing where you hold a long position in the underlying asset and write multiple call options at varying strike prices. Think of it as a ratio buy-write strategy. Your goal here is to capture the premiums from those call options. Keep in mind, variable ratio writes come with limited profit potential, and they're best suited for stocks you expect to have little volatility, especially in the short term.
Key Takeaways
You use a variable ratio write as an options strategy to generate side income from a stock you already own. Apply it when you believe the stock price will stay static for a while. This involves selling multiple call options at different strike prices. The profit comes from the premiums paid for those calls.
Understanding Variable Ratio Writes
In ratio call writing, the 'ratio' refers to the number of options you sell for every 100 shares you own in the underlying stock. For instance, in a 2:1 variable ratio write, you might own 100 shares and sell 200 options. You write two calls: one out of the money, where the strike price is higher than the current stock value, and the other in the money, with a strike lower than the stock price. The payoff structure looks like a reverse strangle, which in options trading involves buying both a call and a put on the same asset. Remember, a variable ratio write has limited profit potential and unlimited risk. It's important to note that variable ratio writes have limited upside and unlimited downside.
When the Variable Ratio Write Is Used
As an investment strategy, you should avoid the variable ratio write if you're an inexperienced options trader because it carries unlimited risk potential. Losses start if the stock price moves strongly up or down beyond your upper and lower breakeven points. There's no cap on the maximum possible loss in this position. That said, for experienced traders, the variable ratio write offers flexibility with managed market risk and can provide attractive income. You have two breakeven points in a variable ratio write position, calculated as follows: Upper Breakeven Point = SPH + PMP, Lower Breakeven Point = SPL - PMP, where SPH is the strike price of the higher strike short call, PMP is points of maximum profit, and SPL is the strike price of the lower strike short call.
Real-World Example of a Variable Ratio Write
Consider this scenario: you own 1,000 shares of company XYZ, trading at $100 per share, and you think the stock won't move much in the next two months. You can hold the stock and still earn a return while it's static by setting up a variable ratio write. Sell 30 of the 110 strike calls on XYZ expiring in two months. The premium on these 110 calls is $0.25, so you collect $750 from the sale. If you're right and the stock stays flat, after two months with XYZ below $110, you keep the entire $750 premium as profit since the calls expire worthless. But if shares rise above the breakeven of $110.25, gains on your long stock will be offset by losses on the short calls, which represent 3,000 shares—triple what you own.
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