Options traders like the ratio write. This is a strategy like the covered call, but when more calls are written than can be covered with stock. For example, if you own 300 shares of stock and you sell four calls, you have a 4:3 ratio write. Three calls are covered and one is not (or, you can describe this as a position that is 75% covered and 25% uncovered).
Macy’s (M) was in a perfect price pattern for the variable ratio write as of the close of trading on August 15. After a positive earnings report three days earlier, price jumped from $34 up to $40 per share, and has gone higher ever since. But it might be time for a turnaround, as shown on the chart.
With Bollinger Bands overlaid on price, the current situation is easily viewed. For the past three days, trading has closed above the upper bands. When this occurs, price usually retreats back into range below the upper band in a matter of only a few days.
Confirming the situation as likely for a strong reversal were two additional signals, the largest one-day volume spike in six months, and momentum’s move into overbought for the first time in the same period. This measurement, Relative Strength Index (RSI), normally reveals index values between 30 and 70. As of the close of August 15, RSI was at 71.57.
This is a perfect situation for the variable ratio write, due to the high probability of reversal. For example, if you own 300 shares of Macy’s, opening a set of four short calls at two different strikes demonstrates how this works. For example, consider the weekly September 9 contracts, expiring in 25 days. (The following week is worth avoiding, as ex-dividend date occurs, and this poses early exercise threat if any short calls have moved in the money.)
For example, you set up a 4:3 variable ratio write with the following short calls:
Sell two 40.50 calls, bid 1.28 each, total 2.56. Adjust downward $10 for trading costs, net $246
Sell two 41 calls, bid 1.04 each, total 2.08. Adjust downward $10 for trading costs, net $302.
Total credit = $548
The attraction of the one-strike ratio write is found in the potential for higher premium income. Traders too often convince themselves that exercise is unlikely, and that time decay is probably going to outpace intrinsic value even if the calls go in the money.
Here's the thinking: You open ATM or ITM positions with one to two months until expiration. It's all time value, so that will evaporate very quickly. Even if the underlying price rises, you can close the exposed portion of the ratio and escape a net loss. Or you can roll the exposed positions forward.
The problem occurs when the underlying price rises so rapidly that you find yourself suddenly in a paper loss position. You have to either close the exposed calls at a loss or roll them forward.
When you roll, you receive more premium, but with this scenario it is likely that the one-to-one calls left are going to be exercised, meaning all of your underlying shares will be called away. Then you're left with those rolled ITM calls. And they're uncovered.
The solution is found in the variable ratio write. Use two strikes instead of one, and you set up a more effective buffer zone. The lower strike should be ATM or slightly OTM, and the ideal higher strike will be either one point or 2.5 points higher. The Macy’s example is ideal because both strikes are close to the money. The chances of a retracement are excellent, meaning both strikes will lose time value and accumulate no intrinsic value by expiration. But if the underlying begins moving closer to the money, you can close the lower-strike calls, possibly at a profit, and avoid the unpleasant prospects of big losses due to uncovered exercise. You can also roll forward to avoid exercise.
The variable expansion of the ratio write reduces risks significantly; but it does not eliminate them. You do have to be willing to live with the risk of sudden, significant movement in the underlying. And if you end up having to roll out of exercise danger, roll all of the calls to a later-expiring variable write. This at least defers exercise while generating more income. Hopefully, you can wait for time decay to make your roll profitable. The risk is mitigated by timing the variable ratio writes for situations just like that of Macy’s – a rapidly appreciating stock gapping high and then showing strong bearish reversal signals.
Besides blogging at TheStreet.com, Michael Thomsett also blogs at the Seeking Alpha and several other sites. He has been trading options for 35 years. He also teaches on the Candlestick Forum website. To check membership, go to Candlestick Forum membership. His new book can be viewed at tinyurl.com/z44kzlu
