Fri Sep 22, 2006: Option Ratio Writing Income (EBAY)

EBAY stock is down 44% from a recent high point. Option buyers might be interested in buying calls but how can option writers (sellers) take advantage of the situation?

A "ratio write" is one approach. That is, buying the stock here and selling both covered calls and also some naked calls for extra income.

The reasoning behind this is that while EBAY stock might be down in price and safer to buy for covered call writing purposes than it was at recent highs, it would still be nice to have that extra income in your account in case it falls further. By selling some naked calls, the breakeven point on the trade is lowered.

The table below shows the option income available now from selling both covered and naked calls on EBAY at some example strike prices and months. The percentages are based on a 100% cash purchase for covered calls, and a margin-based option write for the uncovered ("naked") calls.

Let's consider buying 100 shares of EBAY stock at $26.11 per share and selling 1 January 25.00 covered call at 3.40 plus selling 2 April 32.50 naked calls at 1.40 each.

This is a ratio of 3 to 1. You would be short options for 300 shares but own only 100 shares.

Separately, the percentage yield for the covered call, assuming the stock remains unchanged until expiration so it is called away at $25 per share, is:

($340 - $111) / ($2,611 - $340) = 10.1%

The net income is $340 received from selling the call minus $111 loss on the stock from selling at 25.00 after buying at 26.11. The net upfront investment is $2,611 for purchasing 100 shares at 26.11 minus the $340 option income immediately received by selling the call.

Separately, the percentage yield for each naked call, assuming the stock remains unchanged until expiration so they expire worthless, is:

$140 / $261 = 53.6%

In this case the income is simply the option premium, and the net upfront investment is the margin requirement for selling the naked call.

For today's first quiz question, can you calculate the total percentage return for writing one covered call and two naked calls? (Assume the stock remains unchanged, and as always ignore commissions for simplicity.)

Total income = $340 + $140 + $140 = $620

Total net upfront investment = ($2,611 - $340) + $261 = $2,532

620 / 2,532 = 24.5%, not bad for 7 months, and come January you might be able to sell another covered call for April while you're waiting for the April naked calls to expire.

Of course if the stock starts to shoot up rapidly you'll have to take other action to protect your investment, as described here: What To Do When You Get Caught Short

For today's second quiz question, what is the downside breakeven point for this trade?

26.11 - 3.40 - 1.40 - 1.40 = 19.91 per share, which is a lot safer than just buying it at 26.11, don't you agree?

Until next time, best of luck with your option investments!