• Long 100 shares.
• Short multiple deep out-of-the-money calls.

<Chart of covered short call ratio retrieved from OptionStrat>

A covered short call ratio is a bullish options strategy that involves holding a long position in an underlying stock and simultaneously writing multiple calls on it. A short call ratio like this does not need to be done vertically. Arguably, it is safer to spread out short calls across several different months when doing this because this helps to distribute short gamma and assignment risk. 

For example, one could go long 100 shares and short two calls at about 15 delta. Or they could go long about 30 shares and short a call around 10 delta. Either way, the ratio of the bullish hard deltas (fixed and linear directional risk) to short call deltas is restricted to 10:3. 

This strategy can be VERY DANGEROUS because its potential risk is unlimited if the market makes an extreme move up. The risk is also SEVERE if it moves to the downside since there are long shares which only have minimal protection from the short calls. You would not want to attempt this unless you would be willing to short the equivalent of 100 shares per options contract (if the market moved up to and beyond a certain price level). You would also not want to attempt this unless you were willing to take on the risk equivalent of being long 100 shares.

Expert: Understanding Covered Short Call Ratios

This strategy is more of an enhancement than a hedge: It offers limited downside protection, and can still be dangerous if the short calls add up to more than a third of the bullish deltas from the underlying. A conservative rule on Wall Street is not to try and recover more than 1/3 of a position with a hedge, or else the hedge threatens to develop more risk than the main position and therefore become the position. 

However, there is some room for interpretation there: A stricter governance over a hedge ratio, such as never letting total short call delta exceed 33% of the main position, would help to avoid moderate damage from 2 standard deviation events. However, a more flexible approach (that only limits total short call delta to 1/3 of the long shares at the outset) could be a more neutral strategy that harvests time premium but that requires more active management. Either way, there needs to be some dynamic hedging (systematic tail risk protection) if using short ratios.

At some point, if using the more flexible methodology, a decision needs to be made on whether to buy more of the underlying to protect against a rising spot underlying  price, or to close it at a hard threshold such as a -500% loss. Infrequent but inevitable hits like that will end up hurting too much if this strategy is not managed well. Another dynamic to consider is that the accuracy goes up if smaller deltas are written (sold to open). However, it can be far too difficult and dangerous to try and hedge any deltas written in the low single digits. 

In general, the covered short call ratio strategy is used to generate income from a stock that the trader expects to trade in a range from neutral to bullish, however it requires active attention to manage the risk on these safely.

bullish: A trade is bullish if it would profit from an increase in the underlying (e.g. stock or future) price. Likewise, a trade thesis is bullish if it is expecting the underlying to increase.

delta: A first-order Greek that measures the sensitivity of an option's price to directional movement in the underlying security. Factoring out nonlinear dynamics, the instantaneous value of one delta is worth one share of a stock. This means that if the option on a stock is 40 delta, such as a 40 delta long call or a 40 delta short put, then instantaneously it has the same profit/loss dynamics of being long 40 shares. 

diagonal spread: A spread that has both a vertical and a horizontal difference between strikes. As an example of a long put diagonal, a put could be bought 60 days out and then a put sold 30 days out at a lower strike. The horizontal aspect allows volatility to be traded from one month to another. And the vertical aspect allows a directional thesis to be combined with the strategy.

hedge: To hedge is to set up precautionary or defensive measures which partially compensate against heavy losses or limit further losses. A well-designed hedge is asymmetrical to the larger position it is protecting—in a way that it suddenly increases in size if the larger position takes on losses. A hedge does not aim at being perfect and would generally be content near a limit of recovering a portion of the losses from what it is protecting.

pin risk: A scenario when an option is close enough to the money and close enough to expiration to create a very difficult hedging situation. When market makers face heavy pin risk, this can cause heavy price moves such as a violent whipsaw action.

short call: To be short (sell to open and hold) a call. Unless otherwise hedged, the owner of the short call has unlimited risk and only limited potential gains, which makes this an extremely dangerous strategy in isolation. If left to expire, a short call will achieve max profit if the price ends up underneath the strike price. Shorting a call is a way to express a thesis that one is “not bullish” such as what might be justifiably the case if testing a Call Wall from underneath; being “not bullish” is different than being bearish. For a short call to be profitable, the underlying security must underperform the premium placed on that call by the options market. In other words, a short call profits when the underlying security fails to beat the options market. To be closed early for a profit, there needs to be a decrease in implied volatility or the underlying must have increased less than the options market has priced in for that specific period of time. All short calls have short gamma and short vega but long theta. Short options also come with obligations instead of rights, which means that, at any time, shares can be assigned (100 short shares for each contract); assignment usually only happens when in-the-money and near expiration). Synthetically, a short call becomes logically equivalent to a short put if the trader is also long 100 shares.

standard deviation: In statistics, a standard deviation represents the average expected move (deviation from the mean) with 68.3% confidence. Option theoretical pricing models use standard deviation as a part of their volatility measurement.  

underlying: A reference to the immediate price of the underlying security. This is also sometimes called spot (the spot price of the underlying). The spot price is in contrast to derivatives which have option prices or [forward] futures prices.

writing: We say “write” when a trader sells an option to open a new position. Simply saying “to sell” an option is unclear, as that could mean either selling-to-close or selling-to-open a new position. The most common example of writing is the covered call strategy, which is buying 100 shares in a stock and then selling-to-open a short call on that same stock. In general, writing is to accept an obligation, and there is time-decay income in exchange for that risk (as well as the risk of assignment which is being delivered shares that can create a jump in directional risk).