Inside Trading

Complicating the analysis of covered calls is the fact that the uncovered put has the same market risk. Even though these two strategies are opposite (because calls and puts are opposite), the analysis points out an interesting similarity.

The table below summarizes the similarities and differences of the two strategies.

Covered Call Writing	Uncovered Put Writing
Exercise results no loss, assuming the call’s strike was equal to or higher than stock basis price	Exercise results in stock being purchased at the strike, above market value
Stock has to be 50% paid, with the remainder financed on margin	Collateral requirement is 100% of the strike value
If stock price falls, the call can be closed but net loss might not be avoidable	If stock price falls, the put can be rolled forward to avoid exercise
If stock price rises, the call will be exercised or must be rolled to avoid exercise	If stock price rises, the put can be closed at a profit or held until expiration
Stock ownership includes earning of a dividend	Selling uncovered puts does not include dividend earnings

The comparison between the two strategies does involve the same market risk, with some notable differences. For many, the inflexibility of the covered call in cases where the stock price declines below net basis makes uncovered put writing desirable. When the stock price falls, exercise becomes a possibility; but because no stock is owned, the put can be bought to close and replaced with a later-expiring short put. This rolling strategy can be repeated indefinitely.

The greatest risk in writing uncovered puts is that the stock price could fall substantially. For this reason, it makes sense to focus on stocks with two attributes. First, the fundamentals should be very strong, so that price volatility will not be a large factor as long as the short put is open. Second, write puts on stocks with prices lower than average. A stock’s price can only fall so far, so a lower price per share represents lower market risk. Can a stock price fall to zero? In theory, it can. But the true lowest price risk is tangible book value per share; the value of assets minus tangible assets, minus liabilities. A stock can fall below that level, but it would be quite unusual. Most stocks trade above tangible book value, but rarely fall below.

Another variation worth considering is an expansion of the covered call, to the ratio write. This is a strategy in which more calls are sold than shares of stock are owned. In the basic covered call, you sell one call for every 100 shares you own. In the ratio write, you sell more calls.

For example, if you own 300 shares and sell three calls, you create a 4:3 ratio write. This can be looked at in two ways. First, it consists of three covered calls and one uncovered call. Second it consists of four calls that are each 75% covered. Either way, there is obviously a greater risk in the ratio write. A trader has to be willing to accept higher market risk and ensure that the strike is well above basis in the stock. Writing an in-the-money ratio write should be considered a fairly high-risk venture.

Let’s take an example of ConocoPhillips (COP), where the stock price on January 12, 2015 was $63.13 per share. The February 65 calls were available at 1.75 ($175) each. So a covered call based on ownership of 300 shares would generate income of $525, or 8.3% before annualizing. But a 4:3 ratio write generates $700, or 11.1%.

The obvious advantage of greater income is offset by exercise risk. In this example, there are 1.87 points before reaching the money, so this buffers the risk. However, if the calls do move in the money, the excess call has to be rolled forward or closed to avoid exercise. If the stock price were to move substantially in the money, this risk becomes greater.

An alternative to this idea is the variable ratio write. The basic idea of the ratio write applies but it involves two strikes rather than one. For example, ConocoPhillips (COP) reported a share price of $63.13, and the February 65 call at 1.75 in the previous example. At the same time, the February 67.50 call was valued at a bid of 0.84.

A variable ratio write could be set up with 300 shares and four options: two Feb 65 @ 1.75 and two Feb 67.50 @ 0.84, totaling 5.18 ($518). That is an un-annualized yield based on 300 shares of 2.7%. With 39 days to expiration, this is annualized as: 2.7% divided by 39 days x 365 days = 25.3%.

This is an impressive annualized return, and with 39 days remaining, time value will evaporate rapidly. In addition, two of the short calls are 1.87 points out of the money, and the other two are 4.37 points out. So even with many points of movement in the underlying, the risk in this variable write is limited. Time value will fall rapidly, making it possible to close some or all of the calls at a profit, or to wait out expiration. If the February 65 calls go in the money, the 67.50 calls still have 2.5 points before they reach the money. Due to declining time value alone, there is a good chance that one or both of these higher-strike calls could be closed at a profit.

As an alternative, the short calls can also be rolled forward to avoid exercise. In fact, with two strikes, both higher than the basis in the underlying, you have great flexibility to avoid exercise by rolling forward or closing positions. However, as with all covered calls, you also want to ensure that early exercise in the ex-dividend month will not jeopardize the overall position – leading to having shares called away and loss of the quarterly dividend.

One final point concerning ratio writes and variable ratio writes: because a portion of these positions is uncovered (one of the four options in the example) you will be required to deposit 100% of the strike. In the ratio write, that will be $6,500 and in the variable ratio write, you probably will be required to deposit $6,750, representing the uncovered higher strike. In comparison, the basic covered call has no collateral requirement as long as you own the stock, because the 100 shares per option provide the collateral coverage to eliminate the risk that you see with any uncovered options.