Variable Ratio Writes: Understanding the Strategy, Real-World Application, and Risks

A variable ratio write is a nuanced options trading strategy employed by investors seeking to leverage their long positions in underlying assets to generate additional income through the sale of call options. The term “variable ratio” denotes the varying number of call options written relative to the number of shares owned in the underlying stock. This strategy entails simultaneously writing multiple call options at different strike prices, typically combining “out of the money” and “in the money” calls.

The variable ratio write shares similarities with the reverse strangle options strategy, involving the purchase of both a call and a put option on the same underlying asset. However, while the strangle strategy is typically used to profit from anticipated price volatility, the variable ratio write focuses on generating income through option premiums in a market perceived to exhibit minimal price fluctuations.

Traders deploy the variable ratio write strategy when they expect the price of the underlying asset to remain relatively stable over a specified period. By capitalizing on the premiums paid for call options, investors aim to enhance their overall returns on long positions while mitigating exposure to potential downside risks. However, due to its complexities and inherent risks, the variable ratio write is best suited for experienced options traders capable of effectively managing associated risks.

Despite its potential for generating additional income, the variable ratio write carries significant risk, primarily stemming from its unlimited loss potential. If the underlying asset experiences unexpected price movements beyond the established breakeven points, traders may incur substantial losses. Effective risk management strategies, such as setting clear stop-loss levels and diversifying investment portfolios, are essential when implementing the variable ratio write strategy to mitigate potential downside risks.

To illustrate the application of a variable ratio write, consider an investor who holds a sizable position in Company XYZ, with 1,000 shares currently trading at $100 per share. Anticipating minimal price fluctuations in the near term, the investor decides to initiate a variable ratio write position by selling 30 call options with a strike price of $110, set to expire in two months, for a premium of $0.25 each.

If the price of Company XYZ’s stock remains below $110 at expiration, the investor retains the entire premium collected from selling the call options, effectively enhancing their overall returns on the long stock position. However, if the stock price exceeds the breakeven point of $110.25, the gains from the long stock position may be offset by losses incurred from the short calls, highlighting the importance of diligent risk management in executing options strategies.

The primary objectives of a variable ratio write are to generate additional income through the sale of call options while holding a long position in the underlying asset and to mitigate downside risks associated with potential price fluctuations.

Unlike some other options strategies, such as covered calls, which involve selling call options against existing long positions, the variable ratio write entails writing multiple call options at varying strike prices relative to the number of shares owned in the underlying stock. Additionally, while the strangle strategy is employed to profit from anticipated price volatility, the variable ratio write focuses on capitalizing on premiums paid for call options in a market perceived to exhibit minimal price fluctuations.