The wheel strategy for options (explained with example)

So, you had a conversation with a friend or probably read a book about options. Being a newbie, you search about the strategies to trade options and stumble upon the “wheel options strategy”. Thumbs up to your research work. Now you surf through various websites and intend to learn the strategy. Good news for you, In this article I intend to cover this topic in the easiest way possible so that you can brag in front of your friends about how you made a lot of money with option trading .

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So let’s start with the basics. First thing to keep in mind here is that this strategy is great for short term price fluctuations and this can be used to generate semi-passive income. As you will probably be beginning with options, I will recommend this strategy because it entails lower risk than many other option trading strategies. Most importantly, this strategy doesn’t require me sitting whole day in front of the PC. Place the trade and I can walk away for a while.

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

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. Your account value must be 100x greater than the price of stock. Wondering why? You will understand in a bit.

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  1. Sell a Cash covered Put

sell a cash covered put

Ok, so let’s make this information easier to digest for you.

Cash covered means that you have the money to buy the stock in case they are assigned to you.

By selling a Put, we mean that we write a contract for the other party involved where it has the right to exercise the option but not an obligation to sell the underlying stock to us at a price which is higher than the current market price of the stock (the strike price). As we are selling this right to the other party, in return the buyer pays us a “premium”.

Contract here, is either bought or sold and each contract references to 100 shares of the underlying stock.

  • Possible scenarios that can take place after selling the contract:

    • Scenario #1: When the strike price is lower than the market price

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).

    • Scenario #2: When the strike price is higher than the market price

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. Selling a Covered call option

sell a covered call option

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.

  • Now, just like before there are 2 scenarios in this case:

    • When the strike price is higher than the stock price.

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.

 

    • When the strike price is lower than the stock price.

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 make a lot of money. You get to 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.

Now, so that you get full fledged clarity on the topic I will explain this with the help of an example.

Suppose that I am bullish on Uber stock and now it is trading at $43. Thus, I start by selling a January $40 put for $1.50. Uber stock supposedly stays around $50 during the 2 month period. 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 $1.5. Now, suppose the stock shoots to $55. In this case you make a premium of $150 (1.5 X 100) as the option isn’t exercised. 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. Thus, this is how this whole process comes to an end and you can again start the cycle by selling a covered 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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References:

  1. https://medium.com/mastering-options/how-to-use-the-options-wheel-strategy-5013c9938f4b
  2. https://optionstradingiq.com/the-wheel-strategy/
  3. https://alphapursuits.com/why-i-love-the-wheel-options-trading-strategy/

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