The Option Wheel Strategy involves selling cash-secured put option contracts on a stock with the intention of receiving shares of the stock when the option contract expires. Then in turn selling (writing) call options against the stock otherwise known as a “covered call” until the shares are called away.
How To Use The Wheel Strategy
To use the Wheel Strategy you first need to find a stock that you are comfortable owning shares of. The Stock should have a high enough implied volatility to make the credit premium worth it. See this quick guide on How To Find Stocks For The Wheel Strategy.
Following these steps after you have found a stock that fits your criteria. Let’s say this stock we have found is trading at $150 per share.
- Sell 1 put option with a strike price of $145
- The share price of the stock falls below $145 at the date of expiration of the option
- You then receive 100 shares at a price of $145
- After receiving share you sell 1 call option with a strike price of $150
- The share price rises above $150
- The 100 shares are called away and you receive your credit premium
Once you have reached Step 6 you have completed the wheel strategy and you can then repeat it. If the share price does not fall below the strike price of your option contract you will not go past step 2, so will need to just keep selling put options and collecting credit premium at expiration until eventually the share price does fall below the strike price of your option and you receive shares before continuing to the other steps.
How Volatility Affects Your Trade
Volatility is very important when using the wheel strategy because it directly affects the price of options contracts. When volatility is too low the price of the option will not be high enough to make the trade worth taking. It will be too risky for the amount of profit you will receive for a successful trade.
Implied Volatility
implied volatility is the estimated volatility of a stock’s price. Implied Volatility is what the market is expecting the stock price to move in either direction over a period of time.
Historical Volatility
An asset’s historical volatility is a measure of how much it has fluctuated in price over a certain period of time. This can be useful because it will tell you if a stock is in it’s upper range of volatility compared to how the stock price usually moves.
How Theta Decay Impacts Your Trade
Theta Decay is something you you need to be aware of when using the wheel strategy because it affects option prices. The time value portion of an options premium declines as expiration draws near. Theta will decay more rapidly in the final 30 days before expiration than at any other time. The reason for this is that there is less time remaining for the underlying stock price to make a move that would cause the options contract to finish in the money.
Options contracts are wasting assets, which means they lose value over time. Theta is one of the two main forces that cause options to lose value (the other being vega). If you’re long an options contract, theta decay will work against you and will eat into your potential profits. But when using the wheel strategy you are selling (writing) option contracts so theta decay will work with you and will help you earn a profit.
What Option Expiration Times Should You Use
When choosing option expiration times for the wheel strategy you should try to choose option contracts that expire in 30 days or less as that is how you can use theta decay to your advantage. Many options above 30 days and even into years can move at the same percentage of a stocks price so you will not see as high of returns.
When Should You Use The Wheel Strategy
This Strategy can be very useful if you are already selling put option contracts for income and collecting the credit premium (The price you sold the option for). When the stock’s share price stays above the strike price of your put option and you do not need to take ownership of the shares but you get to keep the credit.
However when the stock price falls below the strike price of your put option which does happen eventually and then you need to take ownership of those shares and that is where you can use the wheel strategy as a way of risk management.
How Much Capital Do You Need
The Wheel Strategy is very capital intensive so you will need a large amount of capital to start using it if you want to generate serious income with it. By using this strategy on multiple stocks at a time you can increase your returns while also minimizing your risk than if you were using it on just one stock.
You can get started using this strategy as long as you have enough capital to cover the amount of shares you will need to take ownership of when the option contract expires in the money.
Trade Management and Risk
Managing your risk is very important and without it can lead to extensive losses. When using the wheel strategy is you need to be very aware of when you want to cut your losses and close the trade. If the stock has fallen to far to make it profitable selling call options against it you should cut your losses and move on to a new trade. Don’t let your losses get to big as will take a long time to recover.
For more on risk management read Risk Management Is The Key To Successful Trading.
What Stocks To Use The Wheel Strategy On
Finding stocks for the Wheel Strategy is very important because not all stocks work for this strategy. A lot of key factors go into choosing the correct stock. Questions you need to ask yourself are
- Is Volatility High Enough?
- Do i want to own this stock?
- How risky is this stock?
- Is the probability of it expiring out of the money high enough
You can set up scans in your trading platform to find these stocks.
Expected Returns
The Wheel Strategy can be great for generating weekly or monthly income. Returns can be very consistent if done correctly without a huge amount of risk. See this article How Profitable Is The Options Wheel Strategy to find out what kind of returns you can potentially expect.
Conclusion
The Wheel Strategy is a very popular options strategy and you will want to make sure you are experienced with options trading before you attempt to start using it.
