The Option Wheel Strategy is a disciplined and highly effective method of selling cash-secured puts and covered calls as part of a long-term trading strategy. It is a mechanism for collecting continuous option premiums and is one of our preferred passive income streams from stock trading.
As with any options trading strategy, the options wheel has one of the lower risk profiles in the options universe. People use the options wheel to supplement their income during early retirement and maintain an interest in the markets. Aim for premiums of between $600-$1,000 each week with this strategy, depending on the status of the market.
This strategy does not intend to be a substitute for our long-term investments. Additionally, selling covered calls is a critical component of the wheel strategy.
Combining Cash Secured Options with Covered Calls allows investors to purchase low (through cash-secured puts) and sell high (via covered calls), maximizing income and capital appreciation on the underlying stock or ETF, referred to as the Wheel Strategy at times.
This strategy provides revenue while the investor waits to buy or sell a security. As opposed to Buy Limit Orders, Cash Secured Puts offer a more favorable risk/reward profile and are the preferred method of acquiring stock. Similarly, after acquiring security, selling Covered Calls rather than Sell Limit Orders provides a superior risk/reward profile when seeking to sell the stock at a higher price.
The strategy's core tenet is that people begin by selling cash-secured puts. We prefer to sell weekly options contracts, which means we would sell a cash-secured put every week until the option is assigned. Once the option is assigned, traders must purchase 100 shares of the underlying stock. At this time, they will switch to selling covered calls and repeat the process until the shares are assigned (called away) again, at which point they will switch back to selling cash-secured puts.
Essentially, people are looking to sell puts continuously, collecting premiums, and hoping that the underlying does not reach their strike. They convert to selling covered calls when their put is assigned (meaning the stock's price falls below the strike price). After that, they pray that the price never exceeds the strike price and collect premiums until they are unavoidably assigned again.
It is not the most sophisticated strategy, and numerous arguments have been made that it is preferable to buy stock and sell covered calls continuously. Nonetheless, we are not here to dispute which strategy is superior but set out the strategy.
The Wheel Option entails the following steps:
Offer to sell a cash-secured put option. While the objective is to collect premiums without assignment, the notion is to accept assignment and hold the stock if the put is assigned.
Construct a straddle. If the cash-secured put is assigned, establish a straddle by selling another cash-secured put and a covered call.
Two covered calls should be sold. If the stock rise in value, the call option is assigned, and people receive three premium payments. If the stock falls and they are allotted 200 shares, sell two covered call options, resulting in five premium payments.
Continue selling covered calls in order to liquidate the stock. As traders buy shares via put assignments, they continue to sell covered calls across the entirety of their position. Once the calls have been assigned, you must begin again. They can either utilize the same stock or a new one.
A simplified version of the Wheel Option consists of the following steps:
Offer to sell a cash-secured put in order to receive premiums without assignment.
Until a covered call is exercised, sell covered calls against the stock if it has been allocated.
Rep the procedure. You are back to square one once you have sold the stock via a call assignment. Repeat the procedure on the same or different stock.
Naturally, the primary danger associated with these tactics is that you will average down too far—that is, the capital loss on the shares would surpass the amount of the premium payments received. The less evident risk occurs when the stock rapidly increases, creating a considerable opportunity cost due to your obligation to sell the stock at the covered call strike price.
How Does Wheel Strategy Work Step by Step
The Wheel Strategy is a mechanism for systematically selling option cash-secured puts and covered calls as part of a long-term trading methodology.
Essentially, traders sell cash-secured puts (CSP) frequently to receive an option premium. If they are ever allocated, they must purchase the stock at the agreed-upon price. Then, while maintaining stock ownership, they sell covered calls (CC) on it to earn more premium. Once the stock is called away, they must sell the shares and then return to sell additional cash-secured puts on the same or another stock.
The Wheel Strategy will compensate people for initiating a long position, allow them to receive dividends and benefit from stock price appreciation while maintaining the position, and compensate them again for closing the position.
Step 1
The total procedure begins with selling a cash-secured put option on a stock and the associated premium. It would help if people chose equities that they are confident in purchasing at a given price and holding for the long term. They must be willing and have the cash available to purchase 100 shares of the underlying stock at the agreed strike price for each option contract sold.
When a put option contract matures, one of two outcomes is conceivable.
First Possible Outcome
The current stock price is greater than the strike price. In this situation, the option is worthless, and traders retain 100% of the premium they get when selling the option. Essentially, you are compensated for the ability to purchase one of their preferred stocks at the agreed strike price on the option expiration date. Then proceed to hunt for further puts to sell.
Second Possible Outcome
The current price of the stock is less than the strike price. In this situation, people must purchase 100 shares of the underlying stock at the strike price for each option contract. Furthermore, they should not be an issue because they were optimistic about the stock and are now purchasing it at a discount, as the price is lower than when they sold the put option. Additionally, they retain the entire premium earned originally in this situation, lowering the stock's overall cost basis.
Step 2
If someone has been assigned a stock, he would want to sell an OTM (out-of-the-money) covered call with a more excellent strike price than the stock's cost. If the stock he has purchased value increases, but the covered call remains ITM (in-the-money) at expiration, you earn from the premium collected plus capital gains over the entry price.
Thus, while holding the stock, he can create additional revenue by selling covered calls numerous times for a higher premium, which lowers the equity's cost basis if all call options expire worthlessly. He continues doing so until the call option stock expires in the money, at which point the shares are called away from him.
Generally, people want to avoid selling a covered call with a strike price that is less than its cost basis, as this will result in a loss on the entire trade. To determine this, they must keep note of all premiums earned and stock appreciation.
At times, they must hold the underlying for an extended time until the uptrend returns, and they return to a reasonable range. This is why it is critical to choose stocks and ETFs that they are comfortable owning for the long term.
When the stock shares are summoned away from them, the Wheel Strategy cycle ends.
If people trade dividend stocks, they may be able to capture some dividends. As a result, the Wheel Strategy can generate a quadruple income stream because they had collected option premium by selling cash-secured puts (before the stock was assigned). Covered calls throughout the wheel cycle, in addition to dividends, earned while holding the shares and possibly some capital gains on the stock price.
Naturally, it is critical to maintaining track of all income made during the various steps of each wheel trade, as without this data, they will be unable to determine whether the absolute position was genuinely lucrative.
Wheel Strategy Example
There is no better method to convey the concept of the options wheel than through examples.
We have numerous real-world instances of how I've accomplished this and how it's generated a constant source of money.
$XYZ is now trading for $100 per share.
Purchase $XYZ for $98 per share with a target price of $120.
In the preceding example, $XYZ stock might be acquired for $2/share less than the cost of a buy limit order. The ideal scenario for this strategy is for the stock to see a brief correction before resuming its longer-term advance. Investors should maintain a neutral/slightly bearish short-term outlook while being bullish in the long run. If the strike price is not achieved and no assignment occurs, the investor retains the premium as revenue. Cash Secured Puts can be rinsed and repeated gradually to create income. If the stock is purchased at $98, the investor can immediately begin to Sell Covered Calls. This enables the investor to sell the stock following a short rally in order to maximize capital appreciation:
After selling the short put, the investor now owns 100 shares of stock $XYZ, trading for $98.
The objective is to sell $XYZ at $120 following the surge.
Sell October 15, 2021, $120 covered call for $2.
What are Selling Options?
The Options Wheel is built around the concept of selling options. Perhaps traders have purchased options in the past, but selling options has always been something they feared due to the "infinite downside risk."
We are here to assure traders that selling options are not nearly as frightening as it appears. Indeed, the more stable and profitable options strategy is to sell options.
People pay the fee up front when they purchase an option to study options. Bear in mind that options are always 100 shares of the underlying stock, which means that if the premium is $1, they must pay $100 to purchase the option.
Cash Secured Put Vs. Covered Call
The options wheel strategy is based on the concept of selling puts and calls. Individuals will sell a cash-secured put and a covered call. These are the most fundamental option selling tactics available, and individuals should be familiar with them prior to being involved in the options wheel.
Cash Secured Put
A cash-secured put is simply selling a put option with the cash on hand to purchase the underlying stock if the price falls below the strike.
Consider the following scenario: Someone sells a $140 put option on AAPL stock that expires in one week. At the moment, the price is $142. There are essentially two possible outcomes:
Apple stock was trading at the end of the week at $141. Because the price is over the strike price, the option expires worthless, and traders keep the premium.
Apple's price after the week is $139.50. Traders will now purchase 100 Apple shares for $140 (a total of $14,000) and retain the premium.
To begin selling this put, people must have at least $14,000 in cash on hand if the option is exercised. This is why the term "cash-secured" is used. Once they sell the put, the $14,000 will be deducted from their account, and they will not be able to reaccess it until the option expires or they sell it out.
Covered Call
Covered calls are the inverse of cash-secured puts. Rather than selling puts, traders will be selling calls. If the underlying stock's price rises over its strike price, they must sell it at the strike price.
The term "covered" refers to the fact that you must already hold the underlying shares to sell calls. If you did not initially own the 100 shares, this is referred to as a naked sell, which most brokerages will not let you do because they would essentially be lending you money (in case the option was called away).
Continue with the preceding example.
Traders purchase 100 shares of AAPL for $150 per share (a total market value of $15,000). Then they sell a call option with a strike price of $155 that expires at the end of the week for a premium of $1 (or $100). There are two possible outcomes:
After the week, AAPL was trading at $154 per share. Because the price is less than the $155 strike price, the option expires worthless, and traders keep the $100 in premiums.
After the week, AAPL was trading at $156. Their option has been exercised, requiring them to sell 100 shares of AAPL for $155. However, retain the premium, as the option has expired. This situation indicates that the option has been "reserved."
Using the scenario above, if the price of AAPL were $175 at the end of the week, people would still be required to give the 100 shares of AAPL at $155 per share, implying a $20 loss each share (total $2,000). However, because they already own 100 shares, they will never lose money if the price increases, but their gains will be limited by the strike price they chose.
Limitations of Wheel Strategy
There is no such thing as a free lunch in the financial markets. A trading strategy is ALWAYS risky, regardless of how safe it appears to be. Options, in general, are a trash fire of danger, and there is a reason why it is compared to a casino.
It is the same with the Options Wheel strategy. It poses a high degree of risk, mainly if you are inexperienced. You must have a thorough understanding of this strategy and be willing to accept the risk of losing money.
Patience is necessary, as deals are typically executed only at expiration. Miss out on specific potential opportunities - if the price does not retrace, the investor will be unable to purchase the stock at a discount. Additionally, the price may soar beyond the covered call's strike price, depriving the owner of additional financial appreciation.
How to Find Suitable Stocks for Wheel Strategy
The key to using the Wheel Strategy successfully is identifying suitable equities. Because you are writing cash-secured puts and covered calls, you should feel safe owning any stock used in the strategy. Additionally, traders should confirm that the stock is reasonably priced, as they may need to purchase 100 or 200 shares.
Several characteristics of high-quality stocks include the following:
Revenue growth.
Net income is positive, and positive free cash flow.
Analyst ratings are bullish.
Volatility is manageable.
Dividend.
The Wheel Strategy's primary risk is in the stock or ETF position itself; if the price falls, people will be forced to purchase the shares at a loss when the put option is assigned. If the stock price continues to decrease, they may be unable to sell a covered call with a strike price greater than the stock's cost basis, in which case they will have to wait for the trend to reverse and the price to rise sufficiently to make the deal profitable.
As a result, the Wheel Strategy's best choices are high-quality stocks with good fundamentals or extensive stock market index ETFs, such as SPY, QQQ, or DIA. Indexes, and their ETFs, perform well because they are liquid, often have low volatility, pay dividends, and generally increase in value over time.
People should never examine stocks or exchange-traded funds (ETFs) that they do not wish to include in their portfolios. There may be occasions when they cannot sell the underlying asset, and it remains in our portfolio for an extended period. Traders do not want to be compelled to work in a position they despise. Select only companies or ETFs that they understand and enjoy on a fundamental level and believe will continue to rise in the long run.
Traders must be prepared to retain the underlying asset for an extended period, as the Wheel Strategy's strength is the length of time the options trader is willing to maintain the stock or ETF as an investor until it returns to the entry price.
Conclusion
The Wheel Option Strategy, or Triple Revenue Strategy, utilizes cash secured puts, straddles, and covered calls to maximize premium income. By following these stock and option selection strategies, you can increase your chances of success and begin earning more money than you would from traditional dividend stocks or fixed-income investments.
If you want to earn money trading options, Top1 Markets is a good option. Our objective is to secure cash flow in retirement by combining stock, options, and cash and applying particular procedures in a specified order to optimize your portfolio's potential income.
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