Options Wheel Strategy: What You Need to Know
The wheel options strategy is an often-used approach used by option traders hoping to generate income. It is designed benefit from turning premiums received through the sale of options into consistent income.
This strategy involves a cyclical process of selling put options, potentially acquiring stock, and then selling call options on that stock. By repeating this cycle, it may be possible to generate consistent income while managing risk. Though relatively simple in concept, the wheel strategy requires a good understanding of options trading and risk management.
In this guide, we’ll break down the strategy's key elements and what you need to know to implement it.
What is a wheel strategy in options trading
The wheel strategy in options trading is a systematic, income-generating strategy that involves selling options in a repetitive cycle. It begins with selling cash-secured puts until the options are assigned. Once assigned, traders then sell covered calls against the newly acquired shares. After the covered calls are exercised, the cycle restarts by selling more cash-secured puts.
It is typically used by traders trying to generate consistent income, especially from stocks they are willing to own or already hold. The strategy combines selling cash-secured puts and covered calls.
Cash-secured put
A cash-secured put is the initial step to potentially acquire shares of a stock at a "discounted" price. This allows you to subsequently sell covered calls against those shares, essentially creating a cycle of selling puts to acquire stock and then selling calls against that stock. The process is repeated to generate consistent income from option premiums; if the put option is exercised, you are obligated to buy the stock at the strike price using the cash you set aside as collateral, allowing you to then enter into a covered call position with those shares.
Covered call
A covered call is the second step, which refers to the act of selling a call option against shares of stock that you already own, essentially generating additional income from the option premium while still maintaining ownership of the underlying stock.
This typically comes after initially acquiring those shares by selling a cash-secured put option as part of the "wheel" cycle; this allows you to collect premium on both the put and call sides of the trade, potentially lowering your overall cost basis on the stock.
Key characteristics of the wheel strategy
The Wheel Strategy is characterized by its cyclical nature: it involves a repeating process where a trader sells cash-secured put options until assigned shares, then sells covered calls on those shares. It then repeats the cycle by selling puts again, essentially "turning the wheel" continuously to generate income from option premiums over time; this cycle can be repeated indefinitely, making it a cyclical trading strategy.
Theoretical maximum profit
The theoretical maximum profit comes from collected premium: the premium from selling puts and the premium from selling covered calls plus any capital gains if the stock is called away at a higher strike price. However, there is no fixed maximum profit because it depends on the movement of the underlying stock and the premiums you receive.
In a scenario where the underlying stock price rises significantly, the profit scenario is as follows. The premium collected from selling the options (both puts and calls) throughout the trading cycle, along with the profit through an increase in the price of the underlying stock, is realized once the shares are called away when the stock price is above the call strike price at or before expiration. The covered call does, however, cap potential profit on the underlying stock at the strike price.
Essentially, the wheel strategy prioritizes consistent income through premiums over large potential gains from dramatic price increases.
Theoretical maximum loss
The theoretical maximum loss occurs if the price of the underlying stock drops to zero. This can result in the loss of the full value of the stock.
The losses may be mitigated somewhat by the premiums received from selling the put and call options, but the strategy still carries significant risk if the underlying stock declines substantially.
While the strategy has a defined risk when selling puts, it introduces additional risk after acquiring the stock.
Using the options wheel strategy
Trading the options wheel strategy involves a systematic process that combines selling put options, acquiring stock, and then selling call options on that stock. The strategy is cyclical, and the goal is to generate income from options premiums while managing risk.
Step 1: Sell a cash-secured put
Sell a put option at a strike price where you're willing to buy the stock if assigned. You are essentially setting a lower price to potentially buy the stock if assigned.
Step 2: Buy the stock (if assigned)
If the stock is assigned to you, you will purchase the stock at the strike price of the put option you sold. At this point, you own the stock, and your goal is to profit by selling calls on this stock to generate additional income.
Step 3: Sell a covered call
Once assigned shares, sell a covered call option against the stock (this should match as one options contract equals 100 shares) to generate additional income, matching the quantity and keeping in mind the options multiplier (one contract per 100 shares).
Choose a strike price that is above the price at which you purchased the stock, setting a target price where you would be willing to sell your shares.
Like the puts, the call option has an expiration date. If the stock price does not exceed the strike price at expiration, the call expires worthless, and you keep the premium.
Step 4: Repeat the process again
The wheel could be restarted if the shares are called away by assignment of the short call. The trader can keep repeating the process by selling cash-secured puts on the same stock, effectively "wheeling" between selling puts and the possibility of acquiring shares.
Wheel strategy example
Let's say a trader sells a cash-secured put option with a strike price of $45, collecting a premium. The stock is currently trading at $50.
Here are two potential scenarios:
The put expires worthless: If the stock stays above $45 at expiration, the put option expires worthless, and the trader keeps the premium as profit. They can then repeat the process by selling another cash-secured put on the stock.
The put is assigned: If the stock drops below $45 by expiration, the trader is assigned 100 shares at $45. Once assigned the shares, the trader then sells a covered call option on those 100 shares with a slightly higher strike price (e.g., $47) to collect another premium for potential income.
Time decay and wheel strategy
In the "wheel" options strategy, time decay is a key benefit, as the value of the options sold (both puts and calls) decreases over time, with all other factors constant, allowing the seller to potentially buy them back at a lower price or let them expire worthless, thus realizing some or all of the premium collected from selling them initially.
Adjusting a wheel trading strategy
Adjusting a wheel trading strategy involves modifying your positions to respond to shifts in market conditions or to better manage risk. Here are some common adjustments:
Rolling options contracts: Extend your position while adjusting the strike price by rolling out and up if the stock moves against you but stays within range, or roll out and down if the stock moves in your favor.
Adjusting strike prices: Align strike prices with your outlook by rolling up if bullish and the stock rises, or roll down if bearish and the stock falls.
Monitor and adjust positions (as needed): Regularly review your open positions to identify potential risks and opportunities for adjustments.
Potential advantages and risks of the wheel options trading strategy
Potential advantages
Could generate consistent income through premiums from selling puts and calls.
Potential to buy stocks at a "discount" through put options.
Repeatability can allow for the opportunity to generate consistent income over time.
Potential risks
Significant downside risk if the stock price declines sharply.
Missed upside potential if the stock rises significantly (because of covered call strike caps).
Requires significant capital to secure puts and hold stocks.
The strategy can be complex and requires active management.
FAQs about the wheel options strategy
What are the rules of the wheel strategy?
Select a stock you are willing to own.
Sell a cash-secured put at a strike price you are comfortable buying the stock.
Be prepared for assignment if the stock falls below the strike price.
Once assigned, sell a covered call on the stock you now own.
Be prepared for call assignment if the stock price rises above the strike price of the covered call.
Repeat the cycle by selling puts and calls as applicable.
Is the options wheel strategy profitable?
The options wheel strategy can be profitable, but its success depends on several factors such as market conditions, the stock you choose, and how well you manage your positions. It’s also important to understand the risks and ensure you are comfortable with potentially holding the stock long-term or managing stock declines. The strategy tends to work best in neutral to slightly bullish markets and requires careful selection of stocks and strike prices to help optimize the premium income.
How to pick stocks for the wheel strategy?
Since the strategy involves selling cash-secured puts and covered calls, you need to focus on stocks that you are comfortable owning and that fit well with the strategy's goal of generating consistent income. Some additional considerations include:
Selecting stable or slightly bullish stocks with more easily forecasted price movements. Avoid highly speculative or volatile stocks (e.g., penny stocks).
Strong fundamentals and financial stability.
Sufficient liquidity in the options market (tight bid-ask spreads, good open interest).
Moderate option premiums (look for stocks with moderate implied volatility).
Strike price selection: Consider stocks that you are comfortable owning at the strike price of the put.
Is the wheel a bullish strategy?
The wheel strategy is generally considered bullish because you are willing to own the stock and typically benefit from a stable to slightly rising price. It’s also considered a neutral-to-bullish strategy that profits from collecting premiums and from potential capital gains if the underlying stock price rises.
It works better in sideways or moderately bullish markets but carries some risk if the stock falls significantly after being assigned.
