What Is a Variable Ratio Write?
A variable ratio write is a strategy in options investing that requires holding a long position in the underlying asset while simultaneously writing multiple call options at varying strike prices. It is essentially a ratio buy-write strategy.
The trader's goal is to capture the premiums paid for the call options. Variable ratio writes have limited profit potential. The strategy is best used on stocks with little expected volatility, particularly in the near term.Key Takeaways
- A variable ratio write is an options strategy used by traders who seek a side source of income for a stock that they own.
- The strategy is used when a trader thinks the stock will remain static in price for some period of time.
- The trader invests in multiple call options at varying strike prices.
- The potential profit is in the premiums paid for the call options.
Understanding Variable Ratio Writes
In ratio call writing, the word "ratio" represents the number of options sold for every 100 shares owned in the underlying stock. For example, in a 2:1 variable ratio write, the trader might own 100 shares of the underlying stock and sell 200 options.Two calls are written: One is "out of the money." That is, the strike price is higher than the current value of the underlying stock. On the other, the strike price is "in the money," or lower than the price of the underlying stock.
The payoff in a variable ratio write resembles that of a reverse strangle. In the options trade, any strangle strategy involves buying both a call and a put on the same underlying asset.
The variable ratio write is aptly described as having limited profit potential and unlimited risk.
When the Variable Ratio Write Is Used
As an investment strategy, the variable ratio write should be avoided by inexperienced options traders as it is a strategy with unlimited risk potential. The losses begin if the stock's price makes a strong move to the upside or downside beyond the upper and lower breakeven points set by the trader. There is no limit to the maximum possible loss on a variable ratio write position. Despite its significant risks, the variable ratio write technique can bring the experienced trader a fair amount of flexibility with managed market risk while providing attractive income.There are two breakeven points for a variable ratio write position. These breakeven points can be found as follows:
Upper Breakeven Point=SPH+PMPLower Breakeven Point=SPL−PMPwhere:SPH=Strike price of higher strike short callPMP=Points of maximum profitSPL=Strike price of lower strike short call