Options Strategy: The Wheel
This article builds on top of my intro to options article, so read that first if you are unfamiliar with the fundamentals of options
What is The Wheel strategy?
The Wheel strategy is a systematic options trading strategy to generate passive income over the long-term with relatively low risk. This strategy is known as the wheel as it comprises of two strategies for entering and exiting a position, like a rolling wheel. To enter a position, you sell a covered secured put. And to exit, you sell a covered call option. Let’s start the wheel rolling by getting into the details with an example! (Keep in mind that the numbers and prices of the examples will change and by the time you read this the option prices will be different).
Step 1: Find a stock
There are two things you need to keep in mind when finding a stock to implement this strategy on.
- The stock needs to be something you believe will rise in the long term.
- The cash amount in your broker account must be at least 100x more than the price of the stock.
For example, currently the stock Pfizer Inc. (PFE) is trading at $58. Assuming you are bullish on the stock and you believe the stock price will continue to increase over time the first condition is met. Secondly, you have over $5,800 in cash, which is $58 x 100 shares (1 option contract is equal to 100 shares of the underlying stock).
Step 2: Sell a cash secured put
What is a cash secured put? Basically it means you write (sell) a contract and the contract is covered by cash. The strike price for the contract is the price you are conformable buying the stock at. If the stock is currently at $58 and you would buy the stock at the same price, you could sell an option with a farther expiration day such as February 04 which is 36 days from today (January 02).
Looking at the option chain from today, we can see that the $58 strike price contract is worth 2.44 or $244 in premium since 1 contract is worth 100 shares. If we sold this put, it would require us to have at least $5,800 as collateral in the margin account. Another way to think about selling a put is that we agree to buy 100 shares of Pfizer at $58 if the stock price is under $58 by the end of day on February 04, 2022 and the option buyer decides to execute their options. Conversely, we will receive the full premium of $244 if the option expires worthless (above $55.56 per share) on February 04, 2022. The chart below shows the profit and loss for the contract over time with the assumption that implied volatility remains the same.
There are 2 scenarios that could happen at expiration:
- The stock stays at (the-money) or above the strike (out-of-the-money). In this case you collect the full premium and repeat this step by selling another put option. If you are feeling more risky and want to collect a larger premium, you should sell a put at a higher strike price, or you could sell an option with an expiration date farther out.
- The stock falls below the strike price (in-the-money). The option buyer executes the option and you are forced to purchase 100 shares at market price. Keep in mind that the nature of American options allows the buyer of the contract to assign the shares at any time, so make sure you have enough cash in case of early assignments.
Step 3: Sell a covered call
Now that you’ve been assigned 100 shares at the strike price we can start to sell a covered call option. A covered call is a call option in which you write (sell) a contract and the contract is covered by your 100 shares of the underlying stock.
Say on February 4th, 2022 we have been assigned 100 shares of Pfizer. The strike price should be at a price you are comfortable with selling all 100 of your shares. For this example, let’s say we want to sell a covered call option for next month at a $65 strike price. The last price sold for the March 18th, 2022 $65 strike is 1.48 or $148 per contract.
As you can see, selling a covered call will decrease the average cost of the share by the premium amount, in this case the premium is 1.48. So instead of a breakeven of $58 which is the price we purchased the shares for, our breakeven is lowered to $56.52 ($58-$1.48).
Conclusion
The wheel is a great strategy for both small and large accounts to enter and exit positions while earning additional profits from the option premiums. Although both option strategies experience limited profits, they also have limited loss as the option contracts are backed by either cash in the margin account (cash secured puts) or by shares (covered calls).
