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You must have got some idea about ratio call write strategy by the name itself. Basically it is selling options against futures or stocks. Frankly these kind of positions work only if your view is right else there can be unlimited losses.
Whenever in any trade there is a chance of unlimited loss, I get uncomfortable. Though I agree at some point we will take the losses out by getting out of the position, but the potential damage it can do by that time is unknown. Since the damage is unknown, I usually do not get into these kind of positions. Actually its in-built now, all these unlimited loss trades or speculative trades does not exist for me.
But ratio call write trade is one of those better trades, and I feel if this article helps traders looking for ratio call write trade, then that would be great.
Ratio Call Write is somewhat like a covered call but comes with a slight twist. Covered calls are usually done on stock vs. options i.e buy stock and sell call. However buying stock and selling call is not unlimited risk. Here we will see why a similar trade is at unlimited risk.
The view of the trader is that the stock will stay in range for the next few days and the volatility will fall. Even if the stock falls or rises by a couple percent points the trader may close this trade for a profit.
How To Trade The Ratio Call Write Strategy:
Buy X Lots in Nifty Futures / Stock Futures or Stock in Cash
Sell 2*X Lots ATM (At The Money) Call Options current month
Which means if the trader buys 1 lot of Futures, he needs to sell 2 lots ATM Call options. If he buys 2 lots of futures, he needs to sell 4 lots of ATM call options.
Note that in covered calls only the same number of ATM/OTM call option is sold, but here the trader sells double the number of call options.
You must be thinking this is a better trade than the covered call because not the same number but double the number of options are sold, but you will be surprised to know what may happen. In short, if risk is concerned, covered call is a better trade than ratio call write.
Risk vs Reward:
Risk is Unlimited and Reward is Limited.
Look at the image below to understand the risk reward of Ratio Call Write trade better:
Now let me do a real paper trade to help you understand better how you will make profits and how you may incur losses.
Date: March 10, 2015
India VIX: 15.53
Nifty Spot: 8700.00
Buy 1 Lot Nifty Future: NIFTY 26Mar2015 Future: 8772.00
Sell 2 Lots of 8700 March Call Option: NIFTY 26Mar2015 CE 8700.00: 160
Credit Received = 160 * 2* 25 = Rs. 8000.00
Note: None of the other websites which teaches the Ratio Call Write Strategy will tell you the hidden price of Futures while explaining this trade. As you can see even though Nifty Spot is 8700.00, a trader has to pay a premium while trading Futures.
Though Nifty is at 8700, the Future is traded at 8772. A difference of 72 points. Mind it, this is a significant issue and cannot be ignored. This can significantly impact the profit and loss of the trade.
Therefore its highly recommended that this trade should be done in cash holding of a stock. Yes you may need a lot of money to trade this with real stocks in your Demat account, but it will be less riskier than doing it with Futures.
If you are thinking why you need to pay a premium to buy/sell futures than the answer is Volatility, Time and prevailing Interest Rate. By trading in Futures you are getting a leverage. 8700*25 = 217500. You need this much cash to buy Nifty 1 lot if Nifty was a stock. But by buying a Future you are getting the same benefit if the Nifty appreciates. And how much cash is blocked? Approx 14,000. Which means you are saving more than Rs. 2 lakh per trade. Who will pay for the interest earned on that money? The Future trader, in the way of premium.
Also, it is not justified if someone buys a stock by paying the full in cash, and someone buys a Future by paying just 10% of it – and make the same profit in the same movement. There should be some justification. Therefore the Future trader pays a premium. Of course on the expiry day both the Future and the stock will show the same price.
Well do you know the above situation can be traded as an arbitrage? For example if Future of a stock is trading at a huge premium, you can sell Future and buy the stock at the same time. Now this is a guaranteed profit for you. For example if Future is trading at 105, and the stock at 100. You can sell Future and buy stock and on the expiry day if the stock is at 100 – you can make 5 points from Future. If the stock is at 105, you make 5 points from the stock. 🙂
Excited? Well don’t get too excited because markets are priced in such a way that arbitrage opportunities are rare now a days. But if you search seriously you may get a couple of trades every month. One day I will write on arbitrage trades, but for now lets leave it.
Coming back to the trade.
Now imagine a situation where Nifty did not move much and stayed at around 8700. See how the Futures will eat into the profits.
Both the lots of 8700 March Call Option will expire worthless. The trader gets to keep Rs. 8000.00.
BUT Future will also be at 8700. Loss from Futures 72 points. 72*25 = 1800.
Total profits: 8000 – 1800 = 6200.
Imagine Nifty to be a stock and also imagine the trader buying Nifty shares at 8700. Now he is at zero loss from the shares, but full Rs. 8000 profit from the call options sold. With futures the premium he paid has gone. Imagine losing this money trade after trade plus the times he made a loss. Future premium will only add to his agony every time he trades this.
Hope its clear that if the stock does not move, the trader will make profit in the Ratio Call Write strategy. Do you really think for a period of 30 days Nifty will not move? No that is not going to happen.
Now coming to the difficult situations. The trade break even is option premium received from selling the calls on the lower end and profits coming from the Future covering the loss till break even is reached, on the upper end.
In the lower end it is: 160 * 2 = 320.
Lower end break even: 8772 – 320 = 8452
Why we are considering the Futures price, why not Nifty spot? Because your profit and loss will be calculated on the Future price NOT the Nifty spot when you initiated the trade.
Calculations when Nifty falling down and on expiry day is at 8452:
Loss from the Futures: 8452 – 8772 = -320 * 25 = -8000.
Both the sold call options expire worthless: Profit = +8000.
Total profit or loss: 8000-8000 = 0.
Which means break even on the downside is 8452. If Nifty keeps falling even after reaching 8452, the trader is at unlimited loss.
Lets calculate break even on the upside:
Calculating this is a bit tricky as we have two sold options, not one. Remember the max loss that can be covered is 320 points but there are 2 options so break even on the upper side is: 320/2 = 160 + 8772 = 8932.
Calculations when Nifty is at 8932 on expiry day:
Profit from the Futures: 8932 – 8772 = 160 * 25 = 4000.
Loss from the sold call options: 8700 March Call Option will be at: 8932-8700 = 232.
((160-232) * 25) * 2 = -3600
Total profit or loss: 4000-3600 = 400. (Note that on the upper end it is very difficult to get a zero profit or loss because there are two options sold, so the loss multiplies by 50 but the profit multiplies by 25.) Still consider this as break even.
Which means break even on the upside is around 8932. If Nifty keeps going up, the trader is at unlimited loss.
Which Calls to Write?
Best is to write ATM calls expiring in next 30 days because they have little time value. If stock does not move much even for a few days the erosion of premium of the sold options will be significant as they are ATM and the trader can exit in profits.
When to Book Profits?
It depends on the comfort level of the trader, but as a conservative trader for me 2-3% per trade is good enough. Whatever, never wait till expiry, any day you see a good profit just exit.
Why Ratio Call Write strategy is better than buying/selling naked futures?
1. There is a big room for profit: In the above trade the room is from 8944 to 8464. If Nifty is anywhere between this on expiry day the trader can be in profit.
2. Whether Nifty goes down or up the trader will feel safe at least until 8944 or 8464 gets breached.
3. If some time passes and Nifty has fallen only a few points the trader can still exit in profits, because the time will eat some premium from the options sold.
4. This is not trading in a panic state of mind. Though not conservative, this trade is still better in terms of keeping stress under control.
5. Still this trade is a unlimited loss strategy so at least I do not recommend it. However if you own real stocks (not Futures) this trade can be traded. Because if the stock falls or does not move the trader makes great money. However if stock keeps rising, the trader can exit one of the call option at a small loss and convert this trade into a covered call.
- Ratio Call Write is a strategy where traders owns stock or futures and sells double the lots of call option against the no of lots of Futures.
- The idea is to take profits from the sold high premium ATM options.
- If stock rises, the trader needs to take stop loss in the calls sold or exit the trade altogether.
- If stock falls the trader can book profits in the sold options and can again sell the options of next month.
- There is a big room for profit in this trade.
- Unlimited risk, so be careful. Calculate your break even points both sides and get out if breached.
Have you ever sold 2 call options against Future buy? If yes please tell us your experience.
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Dilip Shaw, Founder
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