What it means
A call option gives the buyer the right to purchase shares at a set price, called the strike price, before a set date. The seller of the call receives a payment, called the premium, and must deliver the shares if the buyer exercises.
A normal covered call writer sells one call for every 100 shares owned, so the obligation is always backed by shares in hand. In a ratio call write, the investor sells more calls than the shares can cover, for example two calls for every 100 shares owned.
One call is covered, and the other is uncovered, which means that the investor would have to buy shares in the market if exercised. The extra premium is the reward for accepting that open risk.
The strategy works best when the investor expects the share price to stay flat or rise modestly. In that case the covered call earns its premium and capital gain up to the strike, and the extra call earns additional premium that expires worthless.
If the shares fall, the premium cushions the loss a little, but the investor still owns the falling shares. The danger lies above the upper break-even point.
Beyond it, the uncovered call loses money without limit as the price rises, and there is no matching gain. Brokers therefore require margin (a deposit held as security) and approval for uncovered option selling.
The nuance is that this is a strategy for experienced investors who understand options. The position needs active monitoring, because a sudden rise can turn a profit into a large loss quickly.
Anyone considering it should model the worst case before putting on the trade.
In practice
Real-world examples.
Example
A trader holds 200 shares of a stable company trading at $40 and expects little movement. She sells four calls with a $44 strike, receiving more premium than a normal covered call. If the price stays below $44, all four calls expire worthless and she keeps the premium.
Example
An investor sells a ratio call write on a technology stock before earnings, believing the result will be dull. The company surprises the market and the price jumps well above the upper break-even. The investor faces a large loss on the uncovered call and has to close the position.
Example
A fund manager uses a ratio call write on part of a long-held holding to boost income. The risk manager sets a rule to close the position if the share price reaches a level near the upper break-even. This limits the damage from an unexpected rally.
Formula
Calculation
Maximum profit (at the strike) = (strike - purchase price) x shares + total premium received
Upper break-even = strike + (maximum profit / (100 x number of uncovered calls))
Lower break-even = purchase price - (total premium / shares owned)
An investor buys 100 shares at $50 and sells two calls with a $55 strike at $2.00 per share each, receiving 2 x 100 x 2.00 = $400. Maximum profit is (55 - 50) x 100 + 400 = 500 + 400 = $900. The upper break-even is 55 + (900 / 100) = $64, because every dollar above $55 costs $100 on the uncovered call. The lower break-even is 50 - (400 / 100) = $46.Case study
Seen in the real world.
Falconridge Investments is an illustrative, fictional advisory firm that managed the portfolio of a client who owned 1,000 shares of a utility at $30. The client wanted extra income and suggested a ratio call write.
The adviser sold 20 calls (covering 2,000 shares) at a $33 strike for $1.00 each, receiving 20 x 100 x 1.00 = $2,000. The strategy worked for several months while the share price moved sideways, and the client collected the premium.
When an unexpected takeover bid pushed the price to $42, the 1,000 uncovered shares cost the client (42 - 33) x 1,000 = $9,000 to cover, wiping out the premium and more. The illustrative lesson is that a ratio call write earns small gains for a long time and can lose heavily in one event.
Watch out
Common mistakes.
- Treating a ratio call write as a low-risk income strategy, when the uncovered calls carry large potential losses.
- Ignoring the upper break-even price and having no plan for a sharp rally.
- Forgetting that margin requirements can rise as the share price climbs, which may force the investor to add cash.
Questions
People also ask.
How is it different from a covered call?
In a covered call every call is backed by shares, while in a ratio call write some calls are uncovered, which adds income and risk.
When might someone use it?
When they expect the share price to stay steady or rise only a little, and they accept the risk of a big move.
Who can trade it?
Usually only investors whose brokers approve them for uncovered option writing, since it involves significant risk.
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