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Introduction:
A fantastic strategy for investors to purchase low (using cash-secured puts) and sell high (using covered calls) while optimizing the income and capital growth of the stock or ETF is by combining both cash-secured puts and covered calls.
The wheel strategy involves selling a cash-secured put, purchasing stock when/if the put is assigned and then selling a call against this long stock.
When appropriately used, the wheel is an excellent alternative to a buy-and-hold strategy that will produce higher returns with lower volatility.
Definition:
The \”Wheel\” is a four stage options trading technique that starts by selling a cash secured put option with the sale of a put option. You will own stock once this put is assigned, if at all. Selling a call option against this stock is the next step. You will be \”called out\” on the stock, resulting in a flat position, if the price of the underlying increases. \”The wheel\” is produced by repeating this technique.
Cash Secured Put:
A cash secured put is when you write a put and get paid to promise to buy 100 shares of a stock at a specific strike price
Covered Call:
The covered call strategy is when you own 100 shares of a stock and get paid a premium to promise to sell them at the strike price.
Wheel Strategy Diagram System:
- On a stock that you wish to someday purchase, sell cash-secured puts.
- Your short put will be assigned and converted into long stock if the stock price falls below your short put strike price by the expiration date.
- Sell an out-of-the-money call on the long stock as soon as you have it.
- You will be called out, or \”assigned,\” leaving a flat position, if/when the stock rallies to the short call strike price at expiration.
- Resuming the short put trade on the same or a different stock.
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Things to Consider:
Before we initiate a Stock Option Wheel strategy, the following points should be taken into account:
- Stock Purchase: Do we want to own the stock (business?)
- Time Horizon: Do you have a long-term horizon in case we need to hold the shares for long-term?
- Strike Selection: Sell Put options at desired strike price
- Capital available: Do we have enough Capital/Buying power to hold the stock?
- Market outlook: The strategy is implemented in accordance with the direction of the market, whether it is bullish or bearish.
- Volatility: Volatility affects the prices of options. High volatility can lead to higher premiums, which makes the strategy both riskier and more profitable
- Capital and margin requirements: To execute the transaction successfully, this technique needs a sizable quantity of capital and a solid grasp of margin requirements.
- Risk tolerance: If the market swings against the trader\’s position, the wheel strategy\’s selling of options could result in substantial losses.
- Trade Management: Because the approach calls for monitoring and position adjustments, a long-term investment horizon is required in order to manage the trade.
- Trading platform: The wheel method needs access to a trading platform with options trading features as well as a solid grasp of options trading.
Stocks Selection:
When it comes to choose what stocks to trade, we always need to make sure we trade stocks that we firmly believe in for the long term, as well as stocks that we want to hold for the long term, is the best way to approach the system.
Position size is another factor that is crucial because, once step 1 is taken, we need to make sure we have enough capital to hold the shares to begin step 4.
- Other factors that we do consider when it comes to trade the wheel strategy are:
- High Liquidity
- Enough Open Interest
- Blue-chip conpanies
- Profitable business
- Dividend paying business (Not a set stone rule)
- Proper Short Put DTE (Capitalize on Theta Decay)
- Proper Short Call Strike (Do not lock in loses)
- Initiate the covered call approach right after the short put gets assigne
Advantages:
- Premium: We can think of the credit we receive from selling covered calls as lowering our cost basis. Every time we sell a covered call and collect some premium, we are lowering the price of the stock.
- Shares Appreciation: If the stock price is trending upward, we can earn income and profit from it. (Presuming we own the stock and are now in the covered call phase.)
- Options to Shares Risk: Considering the amount of capital needed to hold shares, the wheel strategy has a relatively low risk. There is a very slim chance that the stock will ever reach zero if we always make sure we trade sound business.
- Potential for income generation: Selling options is part of the strategy, and the premium is a potential source of income.
- Market flexibility: The strategy can be used in both bullish and bearish market conditions.
- Customization: The strategy can be tailored to the trader\’s specific market outlook and risk tolerance.
Disadvantage:
- Shares Gains Caped: Not capitalizing on a huge share appreciation.
- Long Stock Unrealized Loss: Having 100 shares of the stock at the start of the covered call period. We can have a huge unrealized loss if the shares experience a severe decline. However, we would already be assuming this risk if we owned stocks.
- Not being patient: It is not a particularly interesting tactic. Options traders may be looking for big returns quickly, but this tactic demands patience.
- Capital requirement: Depending on the stock you select, you will need a sizable account because you must be able to
- Complexity: The method is hard to understand and requires a deep understanding of options trading because it uses different strategies for options.
- Capital requirements: A sizable quantity of capital is necessary for the plan to be successfully implemented, especially when holding long shares.
- Monitoring and alterations: The tactic necessitates continuous position monitoring and alterations, which can be time- and resource-consuming.
- Risk of loss: If the trader\’s position on the market turns out to be wrong, selling options as part of the strategy could lead to big losses.
- Market volatility: The profitability of the strategy can be significantly impacted by market volatility, and extreme volatility can raise the danger of losses.
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Trade Example:
Step 1: Sell Put Option (Cash-Secured Put Option Strategy):
We will start the wheel strategy by selling a cash-secured put on a particular stock that we wish to own (or at least would not mind owning).
We will be obligated to purchase 100 shares at the selected strike (Short Put Strike) price if the stock drops below that level.
As a result, we are more likely to receive an assignment for selling puts with high deltas, which will increase the premium we receive. However, there is a possibility that the stock will continue to decline if we are assigned. Since we really want to own this stock, getting in at a good price should not be an issue; we just need to be prepared to accept paying the \”best\” price because it might decline further.
Step 2: Sell Cash-Secured Put Option:
In this example, we will use the ticker symbol WFC.
We simply need to choose the strike price at which we want to sell a cash-secured put if WFC is currently trading at $42.12. This part will depend on our level of comfort accepting assignment (and once more, depending on how eager we are to own the stock, being assigned may or may not be a \”risk\”).
Short Put Trade Parameters:
Ticker Symbol: WFC
Stock Price: $46.12
Strike Price: $42.5
Premium Received: $0.51 (per share or $51.00 per contract)
DTE: 46 Days
Delta: 21
# Contracts: 1
Type: Short Put
Possible Long Shares: 100 (one Contract = 100 Shares) if assigned.
Step 3: Short Put Option OTM (Expired Worthless):
We will assume that 46 days have passed and WFC is trading at $43.00 in this first step of the wheel strategy. Our $42.5 short put strike price is still trading OTM (out the money) and the put option will expire worthless without any action being required, even though WFC dropped from $46.12 to $42.5. Therefore, in this situation, we just create a new position on WFC or switch to a different product and start at step 1 again.
Step 4: Short Put Option Trading ITM (Short Put gets Assigned):
We will now assume that WFC is currently trading at $40.00 on the expiration date. Even though we had the option to manage this trade before it was assigned, for the purposes of this example, let us assume that we chose to let it expire ITM (in the money). As a result, we will be required to accept assignment of 100 shares of WFC in this transaction at the $42.5 strike price of the cash-secured put option we sold.
Because we received $0.51 in premium for selling this option, the basis cost of this stock is $41.99, which equals the strike price less the premium.
Assuming we currently own 100 shares of WFC, we can move on to Step 5, which entails selling call options above the assigned strike price of $42.50 to convert the position into a covered call (shares plus call options).
Step 5: Sell Call Option (Covered Call Option Strategy):
Now we can sell, a call options at the strike price of $42.50, which is the same as the strike price of the short put assigned, to initiate the covered call option strategy and step five of wheel options strategy.
Remember that selling a call options at the assigned strike of $42.50 is not an obligation but any strike price below the $42.50, we will be locking our trade in a loss if the stock price rises above $42.50. Therefore, knowing how not to lock in loses whilst trading the wheel option strategy is very crucial and you can CLICK HERE to learn how to avoid locking in loses during trade management.
Note:
Holding the stock will occasionally be the only option if the stock has significantly declined relative to our assigned strike price, in which case we may not even find sellable strikes or a sizable premium for selling a call option.
Short Call Trade Parameters:
Ticker Symbol: WFC
Stock Price: $40.00
Strike Price: $42.5
Premium Received: $0.35 (per share)
DTE: 30 Days
Delta: 25
# Contracts: 1
Type: Short Call
Step 6: Short Call Option OTM (Expired Worthless):
We will now assume that 30 days have passed and WFC is trading at $41.50 in this first step of the wheel strategy. Our $42.5 short call strike price is still trading OTM (out the money) and the put option will expire worthless without any action being required, even though WFC raised from $40.00 to $41.5.
Note: So, in this instance, we simply open a new short call position on WFC. This process will continue until our short call options expire ITM (in the money), at which point our 100 shares will be automatically called away and step 7 will begin.
Step 7: Short Call Option Trading ITM (Short Call gets Assigned):
We will now assume that 30 days have passed and WFC is trading at $43.00. The short call option will expire in the money with a strike price of $42.5, trading ITM (in the money), and our existing 100 long shares will be automatically called away from us.
Now that we fully complete the seven steps of the wheel strategy, we can go back to step 1 and sell another cash-secured put on WFC or simply move on to another security.
FAQ
Q: What is the Option Wheel Strategy?
A: The Option Wheel Strategy is a systematic approach to trading options that involves selling cash-secured puts and covered calls to generate income and potentially acquire stocks at a discounted price.
Q: How does the Option Wheel Strategy work?
A: The strategy begins with selling a cash-secured put to potentially acquire the underlying stock at a predetermined price. If the put is assigned, the trader buys the stock and may then sell a covered call against it. The process repeats as long as the desired outcome is achieved.
Q: What are the potential benefits of the Option Wheel Strategy?
A: The strategy allows traders to generate income through options premiums, potentially acquire stocks at a lower price, and participate in the market while managing risk.
Q: What are the risks associated with the Option Wheel Strategy?
A: Risks include the potential for stock assignment, which could tie up capital, and the possibility of missing out on significant upside potential if the stock price rises quickly.
Q: Is the Option Wheel Strategy suitable for beginners?
A: The strategy requires a good understanding of options trading and risk management. It is recommended for experienced traders who are familiar with selling puts and covered calls.
Conclusions:
Compared to other ways to invest, this strategy may not have as much potential for making big profits because it focuses more on making money and managing risks.
The wheel approach is excellent for producing semi-passive, stable income on a constant basis throughout the year. It has lower risk than many other option strategies and typically produces results that are far better than those of a straightforward buy and hold strategy.
By acquiring option premiums via the sale of cash-secured puts and covered calls, as well as dividend distributions where available, it aims to lower the cost basis of your favorite stocks in addition to generating capital gains.
In any case, this is not a method to get rich quickly that will make you millions of dollars overnight. Also, forget about the rush of day trading. The Wheel is a deliberate and frequently dull tactic.
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