The Wheel Options strategy: meaning and how does it work?

Within the world of financial options, there are several tested strategies adapted to different levels of risk. The Wheel Option strategy is a powerful Options trading strategy to make return of investment from an investment in different ways to give a chance of lower risk and higher profitability.

In this article, we explain what the Wheel Strategy is, a low-risk methodology applied to generate small passive incomes.

What is the Wheel Options strategy in financial options?

The Wheel Option strategy is a trading strategy with options, a four step system that involves selling a put option . If the put is then assigned, you will be long on the put option. Now you can sell a call option against the put and ‘called out' on the stock resulting in a flat position.

Repeating the described process makes the strategy a ‘wheel.'

We can also consider the Wheel strategy for Options as both income and stock acquisition strategy. This is evident because the strategy combines selling Cash Secured Puts and Covered Calls.

With the combination of the processes, investors can obtain stocks discount (using Cash Puts) and during the event of assignment purchase the stock at the Short put strike and start selling Covered calls

In general terms, it is an Option strategy that consists of selling a PUT and then buying the underlying shares. If the PUT is assigned, then sell covered CALLs on those shares once they are in the investor's power.

To make it more understandable, these would be the steps:

  1. Selling a PUT: Investor sells a PUT option of the asset that interests them. By doing so, they commits to buying the asset at a certain price (exercise or strike price) if the option is exercised. In return, he receives a premium for selling this option.
  2. Assignment of the PUT and Purchase of Shares: If the price of the asset falls below the exercise(strike) price at the expiration of the PUT option, the investor is obliged to buy the shares at the exercise price. If the option is not exercised, the investor keeps the premium and can repeat the process by selling another PUT.
  3. Selling a covered CALL: Once the investor owns the shares (due to the assignment of the PUT), he can sell covered CALL options on those shares. By selling a CALL, he commits to selling the shares at a certain price if the option is exercised, and again receives a premium for it.
  4. Repetition of the process: If the CALL option is exercised and the shares are sold, the investor can start the process again by selling another PUT option. If the CALL is not exercised, he can sell another covered CALL in the next period.

This strategy receives such a name, wheel, due to the pattern that is formed in the graph of the share prices.

The wheel strategy can be used to generate income, create a long position in a stock, and protect against a drop in the price of a stock.

It is usually a combination of the protective PUT strategy with the covered CALL strategy

How does the Wheel Options strategy work?

Let's break down what was defined above to know how it works step by step. We will also see it with graphs.

Step 1. Sell a Put Option of your desired Underlying.

Remember that selling a PUT means that you are obliged to buy the asset at a future agreed date, at a certain price, in exchange for receiving a premium.

So, when the expiration date arrives, you essentially have two options:

  • If the price of the asset remains above the strike: Close the position and receive all the premium, to start the process again with another underlying, with which we will have already earned some money.
  • If the price of the asset falls below the exercise price (at the expiration of the PUT option): Buy the underlying, that is, the shares in question.

This would be the first step since, selling a put on an underlying, and waiting to see what happens.

You should not get too carried away either, because although it is almost always a very respectable return it will not be a large amount and in most cases you have to wait for the time for the premium to lose its value.

Example

We sell a PUT at 60. In case of being assigned the shares they will give them to you at 60 units of money. The package of 100 shares in that case costs 6000 UM.

When you are presented with the doubt between choosing one expiration date or another, you should calculate on an annual basis which of the two provides the most profitability.

A simple rule:

  • Weekly expiration: Multiply the premium x52. This way, you will get the percentage on the assignment price, 6000 UM in this case.
  • Monthly expiration: In this case you have to multiply the premium x12

It is very common to ignore close expirations due to the feeling of receiving a very low premium, but we must not forget the passage of time, we always have to look for the most favorable.

In the process, it may happen that before being assigned the shares, which in theory is what we are looking for, we receive several premiums before. Whatever it is, one premium or several cycles, we must subtract all the credit received from the strike price, and this will be our break even price.

Break even price (BE) =Entry price (PE)-Total of premiums received before being assigned.

Step 2: Receive the Shares and Sell Calls

We have 100 shares that we have obtained at a price “x”. In reality, we don't care much about having the shares, what we are looking for is selling CALL options on them safely.

Now, selling CALL options forces us to sell the underlying at the strike price in exchange for receiving a premium. So if the asset quotes at a lower price at expiration, we will receive the premium, and we will still have the shares.

Again we face the doubt of which expiration and which strike is the most appropriate.
And here is where we really have to be careful, let's examine with the scenarios that can be presented to us:

It Falls Below our Break Even Price:

If this happens, you should always try to sell the options with exercise prices (strikes) that are above your break even price. That is, you can leave at the same price you entered after a few months of cycle. For example, if the price falls a lot, maybe you have to look for options with more distant expiration dates.

Keep in mind that if the price drops, you will get almost all the value of the premium quickly, this allows you to close that option and roll to another that pays you more. As you have already collected the premium of this last one you have to subtract it from your break-even price. This means that you can lower the sale strikes a bit more.

The Price rises, the position is winning:

Here you should apply the method of looking for the best annualized value as we did with the sale of PUTS. This rule is direct and applies to expirations of one week or one month. At this point, it is highly recommended (and easy) to create an excel that makes the calculation for other temporal periods directly.

Now we can act systematically and sell a CALL in each temporal period, and take it as a dividend. Remember that if you expire above the strike the shares will be sold at that price. When this happens there are many ways to act that depend on the preferences or bias that we may have about the future direction of the asset at that time.

We let them assign us:

The shares are sold at the strike price, and you will have won with the operation the difference between the assignment price minus your break even plus the premium collected in this sale of CALL.

Remember that in all this process we have been able to collect many premiums. Once this is done, the wheel theory says that in the following week we have to sell a Put.

  • Total gain = Covered CALL assignment price-Break-even price + Premiums collected in the process.

We do not let them assign us:

Simply close the CALL option sale operation before the market closing time.

What happened here? You stop making money that you could have made by going only with the shares.

Example of what happens if we do not let the assignment take place:

  • Asset was quoted at 97
  • We sold the CALL 100.
  • At expiration, the asset is at 102.

Our obligation is to sell at 100 with which the movement of 100 to 102 we do not win. We win in this case 3 dollars + Premium entered. This is materialized like this if the act of rolling the CALL is done on the expiration day, if not the effect of the Greeks can make the result different.

With all this, the truly interesting thing is being patient and disciplined to obtain constant returns, one day your actions will be in your portfolio at no cost. And then, you can make the operation with double the contracts. Patience and compound interest really work here.

Wheel Options strategy | The opinion of David Leyguarda

There are few forms as stable and passive to receive returns with “certain security” as this. And if it has to be put in quotation marks because if there is a strong or substantial fall of the asset it can make it really difficult to replace the Break Even price. Therefore, and like everything in investment and speculation, it has its risk.

But without a doubt using the wheel in indexed assets, such as ETF of $SPY $QQQ which, offer the security that cannot be offered by investing in a particular stock allows to add a more stable and secure section to the strategy.

If the cash obtained from the premiums collected is used to expand future positions and number of contracts, with the action of compound interest in several years you can be obtaining interesting returns.

Pros and cons of applying this strategy

As with any investment strategy, it has its pros and cons. Let's take a look:

Pros

Generation of income: By selling PUT and CALL options, the investor receives premiums that can provide a constant flow of income.
Flexibility: If a PUT option is assigned, the investor acquires shares at a potentially lower price. If it is not assigned, he still benefits from the premium received.
Reduction of the base cost: The premiums received for selling options can reduce the base cost of the shares acquired, which can improve overall profitability.
Partial protection: By receiving premiums for selling options, some protection is obtained against small drops in the price of the underlying asset.
Applicability in different markets: The strategy can be implemented in different types of assets, including stocks, indices and ETFs.

Cons

Limitation of profits: By selling a covered CALL option, the potential upside of the underlying stock is limited to the exercise price of the option.
Risk of significant drops: If the market drops drastically, the investor could end up with shares that are worth significantly less than their base cost, even after considering the premiums received.
Long-term commitment: If the shares fall below the exercise price of the sold PUT option, the investor may be obliged to hold those shares for an extended period until they recover.
Transaction costs: Depending on the frequency with which options are sold and bought, transaction costs can accumulate and affect profitability.

Summarily, the Wheel Strategy or Wheel Strategy in financial options is a stable and passive technique to generate income. Although it offers some security, especially when applied to indexed assets such as $SPY and $QQQ ETFs, it is not risk-free. The key is patience and discipline, taking advantage of compound interest. Over time, this strategy can result in zero-cost portfolio stocks and increasing income.

FAQs about the Wheel Options strategy

Is the Wheel Strategy Profitable?

Compared to simply buying and holding strategy, the wheel options trading strategy is profitable when the underlying asset is minorly bullish.
However, if the underlying asset experience a sudden bull, the wheel strategy will lose money when compared to owning the stock.

How do I Choose Stock for Wheel Options Strategy?

While choosing the wheel option strategy, it's important you choose a cheap stick if you have limited capital. Also, be conscious of implied volatility because the higher the implied volatility, the higher the odds the stock will breach both the short put and short call strike piece.

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