A ratio strategy is an options strategy with “unbalanced” sides - meaning you write more contracts than you can fully cover. This chapter covers two ratio writing strategies:
A ratio call write combines a partially covered call with one or more uncovered (naked) calls. For example, an investor establishes:
Long 100 XYZ shares at $53
Short 2 XYZ 55 calls at $4
When you work ratio strategy questions, start by identifying the “heavy” side - the side with extra contracts. Here, the investor is short two calls but owns only 100 shares.
The main point to remember is the risk: a short naked call creates unlimited loss potential. If XYZ rises above the strike price, the uncovered call loses more and more as the stock price keeps rising.
The market outlook is similar to a standard covered call (generally neutral to mildly bullish), but both the risk and the payoff profile are amplified. The best outcome occurs if XYZ rises to the strike price ($55) and stops there.
Now apply that to the position below.
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
A ratio call write reaches its best result when the stock finishes at the call strike price.
Total gain per share = $2 (stock) + $8 (premiums) = $10 per share
Total gain = $10 × 100 = $1,000
Maximum loss = Unlimited
One call is covered, but the second call is naked.
As XYZ rises, the cost to buy those shares rises without limit, so the loss potential is unlimited.
Breakevens = $45 and $65
This position has two breakeven points.
Downside breakeven ($45)
At $45, both calls are out of the money and expire worthless.
Upside breakeven ($65)
$55 + $10 = $65.
Gain or loss if XYZ rises to $70 = $500 loss
$5 × 100 = $500 loss
Gain or loss if XYZ falls to $48? = $300 gain
At $48:
Net = $8 − $5 = $3 per share gain
$3 × 100 = $300 gain
A ratio put write combines a partially covered put with one or more uncovered (naked) puts. For example, an investor establishes:
Short 100 BCD shares at $34
Short 2 BCD 30 puts at $2
Again, start with the heavy side. The investor is short two puts, but the short stock position covers only one of them.
There are two major risks in this position:
The market outlook is similar to a standard covered put (generally neutral to mildly bearish), but the risk and return potential are amplified. The best outcome occurs if BCD falls to the strike price ($30) and stops there.
Now apply that to the position below.
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
A ratio put write reaches its best result when the stock finishes at the put strike price.
Total gain per share = $4 (stock) + $4 (premiums) = $8 per share
Total gain = $8 × 100 = $800
Maximum loss = Unlimited
The naked put can create substantial losses if BCD falls, but the short stock is what makes the overall maximum loss unlimited.
Because a short stock position has unlimited upside risk, the maximum loss is unlimited.
Breakevens = $38 and $22
This position has two breakeven points.
Upside breakeven ($38)
At $38, both puts are out of the money and expire worthless.
Downside breakeven ($22)
$30 − $8 = $22.
Gain or loss if XYZ rises to $45 = $700 loss
At $45:
Net = $11 − $4 = $7 per share loss
$7 × 100 = $700 loss
Gain or loss if XYZ falls to $20? = $200 loss
$2 × 100 = $200 loss
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