Fri Feb 8, 2008: Selling Rambus Ratio Covered Calls

The biggest risk for covered call writers is that the underlying stock declines more than the income they receive from selling the covered calls. As discussed previously, ratio writing is one solution to this. The best solution is proper timing for both the stock purchase and the call sale, but here we're just discussing another example of the ratio writing strategy itself, without timing the call sales.

The stock of Rambus (NASDAQ-RMBS, 17.80) has corrected more than 17% since December, so at least we're timing the stock purchase better than a lot of people did recently!

Chart of RMBS stock

Let's consider buying 200 shares and selling four call options -- two for March, plus one each for May and August. This is a 2 to 1 ratio because we're selling 4 option contracts for 400 shares, twice as much stock as we own (200 shares).

The March calls give us an initial income of 7.6% for the first month. The percentages shown in this table for the May and August calls are based on covered writing, actual returns are higher as can be seen by looking at the uncovered ("naked") tables elsewhere on this site. For now let's let's just calculate the breakeven point, which is our downside risk level:

$17.80 - 1.25 - (1.95 + 2.60) / 2 = $14.275 per share.

Note that as the near-term calls expire, you could sell more to keep the ratio the same. This would increase the percentage return and further reduce your breakeven point. For example, if the March 20 calls expire without the stock being called away, you might then sell two April 20 calls (which are not available yet, but will be then).

If the stock does get called away at 20, you'll capture an additional gain of $2.20 per share. If it doesn't get called in March, it might in April, etc.

The upside risk is if it goes above 25, although at that point you've already locked in some nice profits. The common question at this point goes something like "Yeah this all sounds great and I like the extra income and lower breakeven point but remember we're naked on those 25 calls, what do I do if it gets that high?"

A quick answer, and not a bad idea, is to try to buy 200 more shares on the way up before it gets to 25, then you're covered on all 400 shares.

Faithful readers will recall a more detailed discussion here: What To Do When You Get Caught Short.

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