The wheel strategy is a repeating options income cycle on a stock you are willing to own: (1) sell a cash-secured put and collect the premium; (2) if the put is assigned, buy 100 shares at the strike; (3) sell covered calls on those shares and collect premium; (4) when the shares are called away, start again with a new put. You collect premium at every step, but you carry the downside of owning the stock, and your upside is capped at the call strike. It is one of several strategies to trade options for income.
The wheel suits investors who want semi-passive income and do not need to watch the screen all day. Its risk is similar to owning the stock outright, reduced slightly by the premiums collected, so a large drop in the stock still produces a large loss. This article is educational and not investment advice.
Also, for this strategy, the investor needs to be willing, and have the funds available to purchase 100 shares.
Below I enlist the steps needed to successfully breeze through the strategy. Let’s get into it.
1. Select a stock
If I were to tell you in simple words, choose a stock that you are bullish on or you think will rise in the long term. Also, not to mention, choose something which you can afford. You need enough cash to buy 100 shares at the put's strike price (for example, $4,000 for a $40 strike), because a cash-secured put can be assigned.
2. Sell a cash-secured put
Ok, so let’s make this information easier to digest for you.
Cash-secured (sometimes called cash-covered) means you hold the money to buy the stock if the put is assigned to you.
Selling a put means writing a contract that gives the buyer the right, but not the obligation, to sell the stock to you at the strike price before expiration. For the wheel, the strike is usually at or below the current price. In return, the buyer pays you a premium.
Contract here, is either bought or sold and each contract references to 100 shares of the underlying stock.
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Possible scenarios that can take place after selling the contract:
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Scenario #1: When the strike price is lower than the market price
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In such a case, the option won’t be exercised by the other party because he/she can sell his/her stock at a higher price in the market than what he will get in case he/she exercises the option. In this scenario you keep the premium & make a profit equal to premium X 100 (because premium value is per share and in an option contract there are 100 shares).
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Scenario #2: When the strike price is higher than the market price
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In such a case, the opposite party will exercise the option and you are forced to buy 100 shares underlying the option!
In the case of 1st scenario you make a profit. Theoretically, you can make this money forever, by repeating these steps of selling a contract, expiring worthless, keeping premium, and selling another one. You can continue to do this until the put that you are selling expires in the money (i.e. the other party exercises the option).
3. Sell a covered call
As mentioned in 2nd scenario, you are left with no other option but to buy the 100 shares of the stock at the strike price from the other party. No worries! This will serve as an experience when you trade options further. Holding on to the stock for sometime should not be an issue as you are bullish on the stock (It finally paid off!). Now it’s time to
take another position and turn the wheel. You are now required to take a covered call position. This basically means that in case the other party exercises the option (the option to buy the shares from you, in case the market price rises above the strike price, at the strike price) you have at least 100 shares of that company. Again, in return for getting the right to exercise the option, the buyer of contract pays a premium.
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Now, just like before there are 2 scenarios in this case:
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When the strike price is higher than the stock price.
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In this case the opposite party won’t exercise the option. This is so because it wont purchase from you the 100 shares if it he/she can get those same shares in the market at a lower price. Also, you get to keep dividends (if any) that were distributed during the period.
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When the strike price is lower than the stock price.
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The other party exercises the option & you are forced to sell the 100 shares that you had earlier, to the opposite party at strike price.
In the 1st scenario you keep the premium from the unexercised options plus dividends distributed (if any) during the period. Keep on selling covered calls until assigned. In 2nd scenario, you are required to sell your shares at a price which is lower than the market price. After this, you can get back to step 1 or just sell another put on the same stock if your outlook has not changed.
Worked example
Suppose I am bullish on Uber stock, which is trading at $43. I start by selling a January $40 put for $1.50. Uber stays above $40 through expiration. Then the option expires and you get to keep $150 as premium. You, as a result sell another put with the expectation that the market will be bullish in the near future. However, things don’t turn out in your favor and as a result the option is exercised say at a strike price of $45. You then shell out $4,500 in total & are now in possession of 100 uber shares. You then sell a May $47.50 call for $1.50. Suppose the stock ends May at $46, below the strike. The call expires unexercised and you keep the $150 premium (1.50 X 100). You continue selling covered calls until the strike price (let’s say $60) is less than the stock price (lets say $62). Thus the option is exercised and you are finally paid $6,000 in total (60 X 100) for selling the underlying shares. That completes one turn of the wheel, and you can start the cycle again by selling a cash-secured put.
With this example, I wrap up this article. Hope you got clarity on the topic & don’t forget to leave the comments in the comments section in case you have anything to say about the article.
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To pull option chains and premiums for wheel candidates in Excel, see real-time stock option pricing in Excel.
