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Ratio Covered Call Option Strategy

Covered calls should be a staple strategy for most, whether it's a standalone trade or part of a broader strategy (like the covered strangle for me). They allow us to produce income from an equity position that we might already have. However, like all strategies, there's a trade off. A typical covered call might be 100 shares of long stock and short 1 call against it. Our max profit is now capped at our strike price (plus the credit received) and we collect the credit up front. Despite people's misunderstanding, the best case scenario is the underlying rises beyond our short strike - that's where max profit is. However, most people start trying to fight the trade now seeing the profit they're missing out on.

To avoid this, I trade (most things) at a ratio. This enables us to tailor the risk reward profile of trades to suit our specific preferences. Here's a video that goes further into detail, which I'll outline below. https://youtu.be/mTcCXvFnEuA

  1. Rather than having 100 long shares (+100 deltas) and potentially 100 short shares (-100 deltas) which cancel one another out (which is why you have no more upside potential after that point), we can deploy a ratio.

  2. I essentially never trade traditional covered calls. I always make sure to have MORE long deltas than short. This could be as small as 101 shares against 1 short call, it could be 300 shares against 2 short calls, etc.

    1. The thought process is simple. When we sell the calls we're collecting a credit up front (known profit potential) and sacrificing capital gains potential (unknown profit potential).

    2. We can strike a balance, based on our disposition, to benefit from the known profit potential of the credit received without sacrificing all our upside potential.

    3. If I feel extremely bullish, I'd either wait to sell the short calls or sell a smaller amount up front (you can always scale in).

    4. If I don't have a strong conviction, then I may sell more short calls and leave a smaller subset of deltas uncovered.

    5. Notice how I didn't mention feeling bearish. If you feel bearish, don't be long stock. The short calls wont save your long deltas, they simply minimize the damage.

  3. I prefer to deploy scaling (in nearly all my strategies). It provides way more flexibility:

    1. If I want to buy $500K of IWM, I'd take the current price and figure out how many shares that is in total - at $183.16 that's 2,729 shares.

    2. From here, I'll split the trade up into different sections. Perhaps we enter with a 50% allocation, and decide to scale in the reminder based on various conditions.

    3. This means we'll enter the initial 1364 shares (either via ATM short puts, or buying outright) and we'd be able to sell up to 13 contracts of short calls against - which inherently would be uncapped w/ 64 residual long deltas. 64 long deltas are just 4.7% of the initial entry, too small if we want uncapped upside potential.

    4. What's the right amount? See the decision tree above. Depends on your disposition. In this case, let's say we sell 8 calls against.

    5. By selling 8 calls, we have a maximum of -800 deltas against +1364 long deltas, yielding 564 uncapped deltas or 41% uncapped.

Using a ratio, we can strike a balance between upside potential (unknown profit potential) and credit received up front (known profit potential). This decision can be influenced by your analysis, overall portfolio risk, desire to unwind the position, etc. The trader always has the last say.

Be an Outlier!

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