The past couple of years hasn’t been very friendly for long-term investors. Bear markets are known to be portfolio killers. But just because the prices of stocks are down, it doesn’t mean we can’t make money in the market. Previously we introduced two options trading strategies: selling covered calls and selling cash-secured puts. In this article, we will be discussing the Wheel Strategy: a system that combines both of those other strategies to provide consistent income to your account. What is the Wheel Strategy in options? Let’s find out!
The Wheel Strategy is an options trading system that allows you to collect endless premiums by selling both cash-secured puts and covered calls. It does require some startup capital or a margin account. Once you have started the Wheel Strategy, the premiums can provide a very steady flow of income on a weekly or even daily basis.
Sound interesting? Options trading can often be intimidating, especially for new investors. If you are interested in earning some consistent cash flow to your account, then the Wheel Strategy might be the perfect way to ease into the world of options.
What is the Wheel Strategy?
The basis of the Wheel Strategy in options is really quite simple. It consists of three steps which repeat over and over, which explains the name: Wheel Strategy.
- Sell cash-secured put options on stocks or ETFs you want to own
- Sell these until you get assigned shares
- Sell covered call options on those assigned shares
Pretty simple, right? Just follow these steps and collect option premiums along the way.
One thing you should know is that you might be stuck in step 1 or step 3 for a long time. That’s okay! The wheel will just continue to spin as you collect more and more premiums.
So is it really that easy? It can be! Let’s take a look at an example to illustrate just how simple this strategy can be.
Wheel Strategy Example
Let’s use Tesla’s (NASDAQ: TSLA) stock as an example. For the sake of the example, let’s say that shares of Tesla are trading for about $200.00 per share.
Remember that each option contract, whether it is a put or call, represents a block of 100 shares of the underlying stock. So for each Tesla option contract, it represents 100 shares of TSLA. Make sense?
Step 1 of the Wheel Strategy: Sell Cash-Secured Puts
So step 1 of the Wheel Strategy is to sell cash-secured puts. What does cash-secured mean? It means you need to have the capital or margin to cover the trade if you get assigned. This means you need the equivalent buying power of 100 shares of TSLA at the strike price of your contract.
Let’s write the put option for TSLA at $195.00 with a weekly expiry date. The premium you earn for writing this contract is $100.00.
This means that if by Friday, the price of TSLA stock is above $195.00, the option contract will expire worthless.
At this point, you get to keep the $100.00, and not get assigned any shares. The buyer of the put loses the $100.00 in premium they paid, which went into your account.
So after step 1, you are up $100.00 and ready to sell more puts.
Step 2 of the Wheel Strategy: Getting Assigned
The next week, you sell the $195.00 puts for TSLA again. Same weekly expiry date and the same $100.00 premium.
But this time Tesla has a bad week and on Friday, the stock is at $193.00.
You still get to keep the $100.00 premium, but now you also need to put your capital work and buy 100 shares of TSLA at $195.00.
This will cost you $195.00 x 100 = $19,500.00. Make sure you have this amount of buying power in your account before selling puts. Otherwise, you are selling what are called naked puts.
At this point, you might be thinking you are down $19,500.00. Not exactly.
Remember that in this example, you have already made $200.00 in premium. Now, it’s time to make some more.
Step 3 of the Wheel Strategy: Sell Covered Calls
Selling covered calls is the real money maker of the Wheel Strategy. Not only can you continuously make premiums, but you can also make a capital gain on your 100 shares.
After you get assigned your 100 shares of TSLA, it is time to write covered calls. Let’s write the call option with the weekly expiry at a price of $200.00. Again, let’s say that the premium for this contract is $100.00.
At the end of the week, TSLA is trading at $198.00. So, you collect your premium of $100.00 and hold your shares since they did not meet your strike price of $200.00.
Now, the next week, TSLA begins trading at $198.00 and you write the covered call for $203.00. At the end of the week, TSLA is trading for $205.00. This is where it gets interesting.
You can let your 100 shares of TSLA get assigned away to the buyer of the call option. At this point, you have now made $400.00 in premiums. You are also selling your $195.00 shares of TSLA for $203.00. This is an extra $800.00 in capital gains you just made.
Now, you did miss out on the gains made between your strike price of $203.00 and the closing price of $205.00. That will happen in the Wheel Strategy. This system is meant to capture the most capital you can while limiting your downside risk.
Wheel Strategy Summarized
So in this example, you earned $400.00 in premium and $800.00 in capital gains.
That is a total of $1,200.00 minus any brokerage fees for four weeks of trading.
Now, things will not always go this smoothly, but we wanted to illustrate exactly how powerful the Wheel Strategy can be.
What Do I Need to Start the Wheel Strategy?
The first thing you will need to use the Wheel Strategy in options is a brokerage account that allows options trading.
In Canada, most of the brokerages will require you to apply to trade options. On top of that, you also need permission to sell options as well.
Another thing you will need is a significant amount of capital. This is where many new investors might have difficulty starting with the Wheel Strategy. In Canada, you will also need to apply to have a margin account as well.
What is a margin account? It is an increase in buying power that uses your existing investments or cash as collateral. You will be charged interest on any margin you use.
What are the Risks of the Wheel Strategy?
As with any trading strategy, the Wheel Strategy certainly has its risks.
The single biggest risk is if the stock you are selling puts for implodes. We don’t mean falling by 5%. We mean an implosion of 30% or more in a week. Think of the COVID-19 pandemic market crash.
At this point, not only are you likely to get assigned but you will also be holding these stocks at a significant loss.
This is not an ideal scenario but it does happen. This is why we suggest only using the Wheel Strategy on stocks you are bullish on. It is a great way to buy stocks you like at a lower price. Even if the stock price falls, you can sell covered calls and own them for as long as you want.
Step 1 of the wheel strategy can be risky. There is some limit to the upside with just collecting premiums. On the other hand, the downside is limitless if the stock price falls to zero.
Always know the risks of trading before getting started. We recommend using a practice account if this is your first time dabbling in options.
The Bottom Line: The Wheel Strategy in Options
So there you have it, the Wheel Strategy in options explained. With three simple steps, you can have a steady and consistent flow of income to your account.
With any trading strategy, there are always risks involved. There are not many strategies that will survive a total market crash. Always know these risks before trading with your own hard-earned money.
We hope this article helped you in some way on your investing journey. The Wheel Strategy has been proven to provide a decent return with limited upside but limited downside as well. Is it the right strategy for you? That’s completely up to you to decide. This article is not meant to be financial advice, it is merely providing an introduction to the Wheel Strategy in options.
Thanks again for reading!