Wheel Strategy Options Trading
Wheel Strategy Options Trading is an options trading strategy that is said to be generally low risk. Unlike most other low risk options strategies, it is also quite profitable, which makes it worth learning about.
It can also be considered an improvement of a traditional buy and hold strategy. The reason for this is that there are multiple different ways in which a person can profit from the trade, some of which even encompasses passive income.
How to Execute a Wheel Strategy for Options
- The first step is to sell cash-secured put options.
- Then you sell covered call options.
- And then you repeat this cycle, thus the term "wheel" options strategy.
The reason for making use of cash-secured stocks is so that you can collect the option at a highly discounted price in the event that you ever get assigned. While holding this stock you sell covered calls on it, and then the stock gets called away and you are forced to sell. Then the cycle repeats itself.
Let's look at an example in order to understand where profit can be made:
If stock X is trading at $100, and you are able to sell a put option (enter a bullish trade) with a strike price of $95, let's say the premium is $200 with an expiration date in 14 days.
You need to have $95 X 100 = $9,500 in your account to "cover" the put option. You can read about cash secured put option screeners here.
After those 14 days, the option is above the strike price at $97. In a case like this, the option will expire without any worth due to the fact that it is a put option, and the full $200 will be kept as profit.
What if the price drops below the strike price? If the price drops below the strike price, then you will be forced to buy at the heavily discounted price. Usually, the purchase will have to be a large quantity of the stock; usually a hundred shares per option contract.
Let's look at the same example of stock X, trading at $100, with a strike price of $95 and a premium of $200, expiring after 14 days. If, at the end of the 14 days the stock price is at $94, you will be forced to buy 100 shares of the stock at the agreed upon strike price of $95.
However, because you have collected some premium on the stock at the sale of the put ($200 for 100 shares = $2 per share) the financial loss in the acquisition of the share at a higher price will be accounted for, and in some cases, like this example, you will actually make a small profit. In this case you will not only have 100 shares worth $94 in your possession.
But for every share you will keep the $2, leading to an overall profit of $1 in relation to market value.
In other words, regardless of if the actual stock price rises, or even drops below the strike price, you will make money.
The second step only occurs if your cash-secured put option closes below the strike price and you are forced to buy the shares.
In this case, the key is to be patient and observe the markets. When the possibility presents itself, sell an Out-of-the-Money covered call.
Similarly to above, regardless of whether the stock price increases or decreases, there is an opportunity to make money.
Either the stock price stays below the strike price and the option expires worthless, allowing you to keep the premium. Or it increases and you are profitable in terms of the stock that you are now holding.
It is important to keep track of the money gained and to make sure that you avoid a loss as the stock price moves because your overall profit will now also depend on the value of the asset.
When the shares are called away from you, or you close at higher than the strike price in this step, the cycle repeats.
Advantages of Wheel Strategy Options
The key to being a successful trader is minimizing risk in order to prevent large losses. Through wheel strategy options, this is possible as there is some opportunity for profit both when the market rises and falls.
Although this is not a guaranteed method, like some straddle options strategies, there is some room for error which is not usually the case in options trading.
Long Term Financial Gain
It may not be ideal to be stuck buying 100 shares of a stock that you do not believe in when your sold cash-secured put option expires below the strike price.
However, there are also certain situations where this can be beneficial. If you are bullish on a certain stock in general, and your research as well as a variety of other factors indicate that it will rise over time, then you have managed to purchase large quantities of a potentially profitable stock when it was in a temporary dip and have the option to keep the shares as they grow.
You can still participate in the sale of covered calls, but if you approach with the appropriate caution, then you could continue collecting premiums indefinitely.
Dividend Income Potential on Wheel Strategy Options
If you manage to keep the shares for long enough, as mentioned above, then you also open up the opportunity for dividend income on top of all the other income that you may be making from the options on those shares.
This is a branch of profitability that is completely independent of market conditions, however, it does mean that you may have to hold the shares for months or even years.
Disadvantages of Wheel Strategy Options
These trades generally take extensive periods of time to complete. It is highly recommended to go for options with shorter expiration periods in order to make as much use of the time decay of the option as possible, but even this can take several days, or sometimes even more than a month.
It can also take some time after you have been assigned the shares before you find an opportunity to sell an Out-of-the-Money covered call.
This means that the strategy is not suitable for day traders, or even swing traders. But rather, only to long term traders who are willing to invest in a company that they really believe in and put in additional time in research.
It is possible to invest in options with shares that are not worth a lot of money, but those tend to be more as well. It is better to attempt this on a more established company, with fairly predictable, or stable markets in, and those tend to have higher value shares.
Due to the sheer quantity of the purchase when you are assigned on a stock, this method requires that you have a lot of capital available to you upfront.
If the capital is not available, and it does not make sense in terms of risk for you to be able to lose all the money that you would be using to purchase the shares, then it is not the strategy for you.
For this reason, only well established traders, who are working with larger accounts, can really look at this method.
It is possible to invest in options with shares that are not worth a lot of money, but those tend to be more volatile as well. It is better to attempt this on a more established company, with fairly predictable, or stable markets in order to minimize risk, and those tend to have higher value shares.
Wheel Strategy Options are a great way for seasoned traders with large accounts to minimize their risk when trading with options. It allows the acquisition of stocks at an overall profit and provides various opportunities if you are able to wait for extended periods of time and can identify them.
However, this method is rather complex. If you do not understand it, and do not know how to manage your risk while attempting this trade, rather avoid it. It is important to trade responsibly and understand that every trade has risk.
You might be also curious about What is a Conversion Option Strategy? and What is Options Flow in Stocks?