An Aggressive Way to Double or Triple Your Investment Income
Ready to add a little more firepower to your covered call strategy?
The covered call trading approach is a great way to generate between 25% and 35% a year in your investment portfolio. This strategy involves buying stock in 100-share lots, and then selling one call option for every 100 shares of stock you own.
Selling these option contracts adds additional income to your portfolio, and also reduces the risk that typical investors take by simply buying and holding stock positions. You can find out more information about how this strategy works by reading our covered call primer.
For aggressive traders who are interested in generating more income in their portfolios, there is the ratio write approach. Depending on how you apply this strategy, you can generate double or triple the amount of income that a normal covered call strategy would produce.
Of course, when you increase your income from a strategy, it’s safe to assume that the amount of risk you take will also increase. The ratio write approach that I’m about to explain to you is only for aggressive traders who fully understand the risks with this strategy. But even with the additional risk, if you are skillful in managing your positions, you can produce significantly more income over the long run.
Selling Additional Call Contracts for Extra Income
The ratio write strategy typically involves selling more than one option contract to generate income from your stock position. For example, you could buy 100 shares of a stock that trades at $48, and then sell twice the typical number of call contracts against this position.
Remember, selling a call contract gives us the obligation to sell stock to the other party, if they choose to exercise their option. If the stock is trading above the strike price when these calls expire, you can expect the call buyer to exercise their right and you will have an obligation to sell shares at the strike price.
On the other hand, if the stock remains below the strike price when the calls expire, the other party will almost certainly not exercise their right to buy stock from you. This is because they could buy the same stock in the open market at a cheaper price.
So, using the example above, if the stock traded above $50, we would need to buy stock in the open market to meet our double obligation of selling shares at $50. But if the stock remained below the $50 strike price, we would get to keep twice the amount of income that we normally would have generated (because we sold twice the number of calls in the first place).
Getting Creative With Your Ratio Write
When setting up a ratio write position, there are a number of creative approaches you can use to create extra income. One of my favorite ways to use this strategy is to sell a normal block of calls that are at the money, and also sell an additional block that is out of the money.
As an example, we could buy a stock trading near $50 per share, and then sell a block of call options with a $50 strike price. This would represent a “traditional” covered call trade. Next, I might sell a second block of call option contracts that has a $55 strike price. This second block wouldn’t give me quite as much income (because out-of-the-money options are typically cheaper), but the small amount of additional income can really add up over time.
Another variation of the ratio write approach is to use two different expiration dates for your call options. So in the example above, you might sell one block of calls that expires in a month and another block that expires in three months.
The greater the amount of time before the expiration date, the more expensive the call contracts will be. So by selling a second call contract with a longer term expiration date, we are creating a significant additional piece of income for our portfolio. (Also, by selling a contract that expires in three months, we are giving ourselves more time to adjust the position if necessary along the way.)
Managing Your Risk and Adjusting for Price Changes
It is important to note that you typically need a margin account to use a ratio write approach, and you will need to check with your broker to make sure that you have trading access to be able to sell additional call contracts against your stock position.
If you set up a ratio write position and the stock remains below your strike price, then you will not be required to adjust your option positions. This is because the owner of the call option contracts will have no incentive to exercise his right, and you will not be obligated to sell your shares of stock.
On the other hand, if the stock price moves above your strike price (or one of your strike prices), you may need to make some changes to your positioning. To understand what adjustments are necessary, let’s review our ratio write obligations.
By selling an extra set of calls, we have a potential obligation to sell more shares than we presently own. This means we need to do one of two things:
1. Buy back our extra call position to close out our obligation, or
2. Buy additional stock that we can use to satisfy our obligation.
Just because we have to adjust a position does not mean that the ratio write strategy was unsuccessful. Many times, we are able to sell an additional set of calls for a significant premium, collecting a very attractive amount of income.
If the stock moves higher and we have to buy stock to match against our extra set of calls, the additional premium we received could more than make up for the fact that the stock traded through the strike price of our extra set of calls.
Setting up a ratio write trade introduces a new element of risk to the covered call strategy, because we have a liability that is triggered if the stock continues to trade higher. But by managing this liability through buying back stock when necessary or buying back portions of our call options, we can generate significantly more income, which will compound over time.
As always, I would love to hear your comments or questions on this strategy. Please send your emails to Editors@ProfitableTrading.com and mention this article on covered call ratio writes.