Ratio writing
A ratio strategy is an options-based strategy that involves “unbalanced” sides. We’ll discuss these two “ratio writing” strategies in this chapter:
- Ratio call writes
- Ratio put writes
Ratio call writes
A ratio call write is a partially covered call paired with uncovered (naked) call(s). For example, assume an investor establishes the following positions:
Long 100 XYZ shares at $53
Short 2 XYZ 55 calls at $4
The key to answering ratio strategy questions is focusing on the “heavy” side. The investor writes two calls, one covered by the 100 shares and one naked (uncovered). The most significant takeaway is the risk the investor faces. Maintaining a short naked call will always subject an investor to unlimited risk. The further XYZ’s market price rises, the more they lose on the naked call.
The market sentiment is similar to a typical covered call, although the risk and return potential is amplified. The investor is betting on a relatively flat/neutral market and will obtain their maximum potential return if the market price slightly rises to $55 and does not go further.
Now that we’ve discussed the basics of this strategy, can you answer the following questions?
Long 100 XYZ shares at $53
Short 2 XYZ 55 calls at $4Maximum gain?
Maximum loss?
Breakevens?
Gain or loss if XYZ rises to $70?
Gain or loss if XYZ falls to $48?
Can you figure it out?
Maximum gain = $1,000
As we discussed above, covered call writers mostly seek flat/neutral markets. If the market price rises slightly to $55 (the calls’ strike price), the stock position gains $2 per share. As long as the market price increases no further, both options expire “at the money.” The investor keeps the two $4 premiums for a total of $8 per share. The $2 stock gain plus the $8 in collected premiums is a total of $10 per share, or $1,000 overall ($10 gain per share x 100 shares).
Maximum loss = Unlimited
Although one of the calls is covered, the other is naked. If XYZ’s market price rises above $55, the calls go “in the money” and will be exercised (assigned). The investor can sell the 100 shares they own through the assignment of the covered call, but must go to the market to obtain the other 100 shares for the assignment of the naked call. The further XYZ’s market price rises, the more expensive it is to buy those shares. Therefore, the investor is subject to unlimited loss potential.
Breakevens = $45 and $65
This strategy has two breakevens - one on the downside and one on the upside. We’ll focus on the downside breakeven first. The investor collects $8 per share in total premiums, which must be “lost” on the downside to breakeven. If XYZ’s market price falls to $45, they lose $8 per share on the stock, offsetting the two option premiums. At $45, both calls are “out of the money” and will expire worthless.
Let’s look at the upside breakeven now. We determined above that the investor reaches their maximum gain of $10 per share when XYZ rises to $55. The naked call subjects the investor to losses if the market price rises above $55. If the market price rises to $65, the investor loses $10 per share on the naked call, offsetting the $10 gain per share they had when XYZ was at $55. The covered call is irrelevant, as it will be assigned and force the investor to sell the shares they already own at $55.
Gain or loss if XYZ rises to $70 = $500 loss
Continuing from our upside breakeven example above, the investor breaks even at $65. If they continue to lose on the naked call the further the market price rises, an additional $5 per share rise would result in an additional $5 per share loss. A $5 per share loss is $500 overall ($5 x 100 shares).
Gain or loss if XYZ falls to $48? = $300 gain
At $48, both call options are “out of the money,” will expire worthless, and the investor keeps the $8 in premiums collected. The stock loses $5 per share as it falls from the original $53 purchase price. The $8 in premiums collected minus the $5 stock loss is a total gain of $3 per share, or $300 overall ($3 x 100 shares).
Ratio put writes
A ratio put write is a partially covered put paired with uncovered (naked) put(s). For example, assume an investor establishes the following positions:
Short 100 BCD shares at $34
Short 2 BCD 30 puts at $2
Again, the key to answering ratio strategy questions is focusing on the “heavy” side. The investor writes two puts, one covered by the 100 short shares and one naked (uncovered). The most significant takeaway is the risk the investor faces. Maintaining a short naked put subjects an investor to significant risk. The further BCD’s market price falls, the more they lose on the naked put. Additionally, the short stock position subjects the investor to unlimited risk, as the position loses more the further the market price rises.
The market sentiment is similar to a typical covered put, although the risk and return potential is amplified. The investor is mostly betting on a flat/neutral market and will obtain their maximum potential return if the market price falls to $30 and does not go further.
Now that we’ve discussed the basics of this strategy, can you answer the following questions?
Short 100 BCD shares at $34
Short 2 BCD 30 puts at $2Maximum gain?
Maximum loss?
Breakevens?
Gain or loss if BCD rises to $45?
Gain or loss if BCD falls to $20?
Can you figure it out?
Maximum gain = $800
As we discussed above, covered put writers mostly seek flat/neutral markets. If the market price falls to $30 (the puts’ strike price), the stock position gains $4 per share. As long as the market price falls no further, both options expire “at the money.” The investor keeps the two $2 premiums for a total of $4 per share. The $4 stock gain plus the $4 in collected premiums is a total of $8 per share, or $800 overall ($8 gain per share x 100 shares).
Maximum loss = Unlimited
While the investor is subject to substantial losses on the naked put, the short stock position is the primary risk driver. The further BCD’s stock price rises, the more expensive it is to close (repurchase) the position. Both puts expire worthless if BCD’s market price is above $30, allowing the investor to keep both premiums. Regardless, the puts do not cover the short stock position, so the investor is subject to unlimited risk potential.
Breakevens = $38 and $22
This strategy has two breakevens - one on the upside and one on the downside. We’ll focus on the upside breakeven first. The investor collects $4 per share in total premiums, which must be “lost” on the upside to breakeven. If BCD’s market price rises to $38, they lose $4 per share on the short stock, offsetting the two option premiums. At $38, both puts are “out of the money” and will expire worthless.
Let’s look at the downside breakeven now. We previously determined that the investor reaches their maximum gain of $8 per share when BCD falls to $30. The naked put subjects the investor to losses if the market price falls below $30. If the market price drops to $22, the investor loses $8 per share on the naked put, offsetting their $8 gain per share when BCD was at $30. The covered put is irrelevant, as it will be assigned and force the investor to buy back the short shares at $30.
Gain or loss if XYZ rises to $45 = $700 loss
At $45, both put options are “out of the money,” will expire worthless, and the investor keeps the $4 in premiums collected. The short stock loses $11 per share as it rises from the original $34 purchase price. The $11 stock loss minus the $4 in premiums collected results in a total loss of $7 per share, or $700 overall ($7 x 100 shares).
Gain or loss if XYZ falls to $20? = $200 loss
Continuing from our downside breakeven example above, the investor breaks even at $22. If they continue to lose on the naked put the further the market price falls, an additional $2 per share drop would result in an additional $2 per share loss. A $2 per share loss is $200 overall ($2 x 100 shares).
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