Mon Mar 13, 2006: Covered Ratio Writing Example (VRX)

To get a higher yield from selling covered call options, some investors sell more calls than are actually covered by the amount of underlying stock they own. This is sometimes called "ratio writing" or "covered ratio writing".

For example they sell 10 calls (for 1,000 shares) when they only own 500 shares. This would be a ratio of 2 to1. Only half of the calls would be covered, the other half would be uncovered ("naked calls").

The covered calls can be sold with no additional deposit into the account once the stock is paid for. The naked calls require a margin deposit, typically 30% of the value of the underlying stock, although this amount varies from broker to broker.

If the stock stays the same or goes down, the naked calls provide additional income. If the stock goes up too far, they can result in a loss.

Let's consider an example for Valeant Pharmaceuticals (NYSE-VRX), which is a volatile stock with relatively high option premiums, using actual closing prices from today. Say we buy 500 shares at $19.41 and sell 5 covered calls, the April 20.00 calls, at $200 each for an income of $1,000 plus another 5 naked calls, the April 22.50 calls, at $105 each for an additional income (yes, we're greedy) of $525.

As usual we'll ignore commissions to simplify the arithmetic.

For each 100 shares and covered call we'll have to deposit $1,741 not $1,941. This is called a "buy-write" (buy the stock, write the call). The stock will be fully paid for because you get $200 income immediately. So the total investment for writing the covered calls will be 5 * $1,741 = $8,705. $1,000 income on an $8,705 investment is a return of 11.5% as you can see in the table. The table row is based on one option but the percentage is the same no matter how many you write. To calculate the percentage you divide 200 by 1741 or 1000 by 8705, same result.

Margin requirements for naked writing are a little complicated. In this case the margin requirement of $273 per 100-share contract is calculated as follows: 30% of the value of the underlying stock (0.30 * 1941 = 582) minus the out-of-money amount (2250 -1941 = 309). Thus, 582 - 309 = 273.

If the stock goes up then the margin requirement for the naked calls will also go up; if the stock goes down then the margin requirement for the naked calls will also go down. Please consult your broker for details, or email me at FreeOptionInfo@att.net if you have any questions about this (or anything else related to options).

For selling ("writing") 5 naked calls the margin requirement will thus be 5 * $273 = $1,365. An income of $525 on a $1,365 investment is 38.5% as shown in the red part of the table.

OK, now it's time for today's quiz (I warned you these would be getting tougher!):

1) What is the total one-month percentage return on this position assuming the stock remains unchanged on expiration day Friday April 21?

2) What is the downside break-even point?

3) What is the upside break-even point?

Drum roll…….the answers are:

1) 15.1%

2) $16.36

3) $26.14

The total income is $1,525 and the total investment is $10,070. So 1,525 / 10,070 = 15.1%. Note that by ratio writing instead of just covered writing your unchanged yield is enhanced by 3.6% because it was only 11.5% for straight covered.

The downside break-even point is the stock purchase price of $19.41 minus the income per share of $2.00 for each covered call and $1.05 for each naked call. 19.41 - 2.00 - 1.05 = 16.36 which is your net cost per share and thus your breakeven point because if the stock goes below that you will start to lose money. Note that by selling the naked calls you lowered your downside break-even point by $1.05, which makes it a little safer in terms of downside price risk.

Upside price risk is increased. There is no upside price risk for a fully covered position. You can only make money if it goes up. But when you add in the naked call writing there is some upside price risk. If the stock goes above 20.00 you will have an additional gain of 0.59 per share since you bought at 19.41 and will be called away at 20.00 plus you keep the 2.00 and the 1.05 for a total income of 3.64 per share. But if it continues to rise above 22.50 you will start to incur an obligation to the call buyer which will equal $3.64 per share if the stock finishes in-the-money by 3.64 with respect to those naked calls, i.e. at a price of 22.50 + 3.64 = 26.14 so that's the upside breakeven point; above that you will be losing money unless you take some action in the meantime.

For example, consider that by placing a GTC buy stop for an additional 500 shares at say, $22, you could rest assured that should the stock start running up you would automatically cover those 5 naked calls. Of course if the stock gaps above $22 on the open you will get filled at a higher price.

That's enough for today. I'm sure many of you have questions about what else you can do if the stock soars, etc. We'll cover that in future discussions, from a variety of angles. There are many other strategies to handle this situation.

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