Variable ratio writing involves writing two option contracts using a fixed number of shares of an underlying security, with a common approach being a two-to-one strategy. This strategy requires planning and precision and should only be used when the underlying security has limited volatility.
Variable ratio writes are an investment strategy that involves writing two strikes using a fixed number of shares of an underlying security. In most variable ratio writing examples, the underlying security will be at least one hundred shares. The basic idea for variable ratio writing is to hold a long position safely while writing multiple option contracts at different strike prices.
The process involved with a variable rate script is somewhat similar to that of a rate call script in general. What distinguishes the approach is that a variable ratio write will involve two written options for the block of one hundred shares of the underlying. The type of calls can vary with this approach, as variable rate writing can be accomplished with money as well as without money.
A common approach to a variable ratio script is to employ what is sometimes called a two-to-one strategy. This involves being long all 100 shares and writing two different calls at different strike prices. One call will go into the money, and the second will be written as an out-of-the-money call. It is understood that this approach provides greater chances of return for the trader, since a wider range of possible movements in the security is explained with the different types of calls.
Employing the use of a variable ratio script must be approached with planning and precision. In general, it is not a good idea to use a variable ratio script unless the trader is reasonably sure that the underlying security has no more than a limited amount of volatility. The stability of the underlying is crucial to the success of this type of options strategy, as unanticipated changes in the value of the underlying security will throw the attractiveness of strike prices out of line. For this reason, financial advisors tend to advise clients to approach the idea of a variable write ratio only when all feasible market conditions and their impact on security have been taken into account.
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