Variable Ratio Options Trading: Strategy, Risks & Rewards

Variable ratio write is an options trading strategy where, regardless of fluctuations in the price of the underlying asset, there is a limited potential of profit and unlimited losses. The limited profit potential is attributed to the investor’s pursuit to capture the premium reward for the call optionCall OptionA call option, commonly referred to as a "call," is a form of a derivatives contract that gives the call option buyer the right, but not the obligation, to buy a stock or other financial instrument at a specific price - the strike price of the option - within a specified time frame..

Thus, the variable ratio write strategy is regarded as a safe way of trading a stock that is expected to face volatility within a short period. A variable ratio write is related to other ratio write strategies that are characterized by traders simultaneously combining their stock while writing multiple call options.

Summary

• Variable ratio write refers to a trading practice with limited potential profit and unlimited losses despite the changes in the price of the underlying stock.
• Because of its unlimited risks potential, inexperienced traders are strongly advised against engaging in variable ratio writes.
• A variable ratio write is only executed after performing a thorough fundamental, technical, and economic analysis.

How Variable Ratio Write Works

The variable ratio strategy represents the number of options that an investor sells per 100 stocks held in the underlying stock. While the trading strategy is similar to a ratio call write, the same cannot be said of its writing options. The trader will sell in-the-money and one out-of-the-money call, rather than writing at-the-moneyAt The Money (ATM)At the money (ATM) describes a situation when the strike price of an option is equal to the underlying asset's current market price. It is a concept of calls.

Consider a typical scenario of a 2:1 variable ratio write. In such a case, the trader will be owning 100 more shares of the underlying stock. The trader can write two calls, one in-the-money, and one out-of-the-money call. Eventually, the resulting loss or profit profile disappears, leading to less profit potential.

At the same time, the trader can profit from the purchased wider price range. However, it is worth noting that all the options strategies involved are derived from the same underlying stock and with a similar date of submission.

The variable-ratio write strategy is not ideal for inexperienced options traders due to the unlimited risk potential. Risk begins when, by expiration, the price is strongly on the downtrend or upward trend beyond the lower or upper break-even pointsBreak-even Point (BEP)Break-even point (BEP) is a term in accounting that refers to the situation where a company's revenues and expenses were equal within a specific accounting period. It means that there were no net profits or no net losses for the company - it "broke even". BEP may also refer to the revenues that are needed to be reached in order to compensate for the expenses incurred, respectively, and it makes a maximum possible loss limitless on a variable ratio write.

Despite the significant risks associated with the strategy, it provides a fairly attractive reward to the amateur trader with a moderate level of flexibility with managed market risks.

Break-Even Points of a Variable Ratio Write

A variable write position is characterized by two break-even points – the upper break-even point and the lower break-even point. The following approaches are used to find the two break-even points:

1. Lower Breaking Point = Strike Price of Lower Strike Short Call – Points of Maximum Profit

2. Upper Breaking Points = Strike Price of Higher Strike Short Call + Points of Maximum Profit

Step-by-Step Process of Determining the Break-Even Points

An options trader is required to first perform economic, fundamental, and technical analysesTechnical Analysis - A Beginner's GuideTechnical analysis is a form of investment valuation that analyses past prices to predict future price action. Technical analysts believe that the collective actions of all the participants in the market accurately reflect all relevant information, and therefore, continually assign a fair market value to securities. before executing the variable ratio write. It can be done by factoring in the resistant level at or near the upside break-even point and the support price level at or near the downside break-even point. Afterward, the trader should expect little volatility of the underlying security.

The next stage is to study the option chain and start selecting the option for use in the construction of the variable ratio write strategy. Since the strategy requires the ownership of the underlying security, the trader should be aware of the underlying security’s current trading price.

The next step involves determining the upper break-even point and the lower break-even point using the formulas above. There is neither a profit nor a loss at the price points. The upside break-even point, as with the downside break-even point, offers a comparative greater value, hence the name “variable.”

The technique for calculating the upper breaking point is premised on the idea that when a variable ratio write is executed, there are call options at different strike prices. Similarly, the downside break-even point is based on the fact that the variable ratio write returns a profit when the price of the underlying security is greater than the downside break-even point and less than the upside break-even point.

In the next stage, the trader is required to understand the resultant profit zone. After identifying the break-even points, the trader should be aware that only when the price of the underlying security trades between the break-even points is when a profit can be realized.

Two possible scenarios may result from the determined zone, i.e., the potential for unlimited losses and the limited profit. A loss is realized when the price of the underlying security either moves the upside break-even point or below the downside break-even price point.

In theory, the cost of the underlying security can trade down to zero or rise to infinity, which is reflected by the potential for unlimited losses. On the other hand, the limited profit is realized only when the price of the underlying security is fixed until expiration from where the profit is derived from the time option.

Practical Example

Consider Stock XYZ is trading at $100, and an investor who owns 1,000 XYZ shares is certain that over the next two months, the prices are unlikely to move much. It is unlikely that the trader will reduce or add their stock position. The investor can still make a positive return should the projection be correct.

Using a 2:1 variable ratio write (meaning the trader will be long 100 shares of the underlying stock), a variable rate can be initiated to achieve their objective by selling 30 out of his 110 strikes that will expire in two months. The 110 strikes calls give an option premium of $0.25.

Therefore, the traders will collect a total of $750 from the option sales. The trader will book the entire 750 premium as a profit of XYZ shares sticks below $110 after four months. However, if the shares exceed the break-even price of $110.25, the long stock positions will reward more than short calls losses offset. It is after the traders sold more than what he owns.

More Resources

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™Program Page - CBCAGet CFI's CBCA™ certification and become a Commercial Banking & Credit Analyst. Enroll and advance your career with our certification programs and courses. certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Collar Option StrategyCollar Option StrategyA collar option strategy limits both losses and gains. The position is created with the underlying stock, a protective put, and a covered call.
• Strike PriceStrike PriceThe strike price is the price at which the holder of the option can exercise the option to buy or sell an underlying security, depending on
• Long and Short PositionsLong and Short PositionsIn investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short).
• Fundamental AnalysisFundamental AnalysisIn accounting and finance, fundamental analysis is a method of assessing the intrinsic value of a security by analyzing various macroeconomic and microeconomic factors. The ultimate goal of fundamental analysis is to quantify the intrinsic value of a security.