- What is the Wheel Options Strategy?
- What are Covered Calls, Cash-Secured Puts, Premiums and collaterals?
- How to implement the Wheel Options Strategy
- Managing Risk with the Wheel Options Strategy
- How to Choose the Right Stock for the Wheel Strategy Options?
- Wheel Options Strategy Example
What is the Wheel Options Strategy?
The Wheel Options Strategy in investing is a combination of two options strategies – covered calls and cash-secured puts – that can help investors generate income, potentially increase returns, and manage risk. This strategy is suitable for investors who have a long-term investment horizon and are looking for ways to generate additional income from their portfolios.
This guide will introduce the basic concepts behind the Wheel Strategy Options, including covered calls, cash-secured puts, premiums, and collateral. This strategy is usually used by experimented traders and even if it can be extended to long term investors, we don’t recommend it for beginners.
What are Covered Calls, Cash-Secured Puts, Premiums and collaterals?
The Wheel Options Strategy is not something particularly difficult to understand, even if you are a beginner but it might use new words that you have never encountered in the past. Once you understand this terminology, then everything will start to be much easier.
First, let’s define what is a collateral, a covered call and a cash-secured put.
What is a Collateral?
In options trading, collateral refers to the money or assets that an investor must deposit with their broker to secure the obligations under an options contract. The collateral can be cash or directly the stocks you want to create a contract for. The collateral is used to ensure that the investor has the financial resources to fulfill the obligations of the options contract if it is exercised.
What is a Covered Call?
A covered call is a strategy where an investor holds a long position in an asset, such as a stock, and sells a call option on that same asset. By selling the call option, the investor can receive additional income in the form of the option premium (basically a bonus). If the stock price rises, the investor may have to sell their shares at the agreed-upon price (the strike price), but they have already received income from the option premium.
What is a Put Option?
A put option is a financial contract that gives the buyer the right to sell a stock at a predetermined price (strike price) within a specified time period. The seller of the put option is obligated to buy the stock at the strike price if the buyer exercises the option. Put options are used for risk management or speculation, allowing the buyer to limit potential losses or the seller to generate income.
What is a Cash-Secured Put?
A cash-secured put, on the other hand, is when an investor sells a put option while also setting aside enough cash to buy the underlying asset at the agreed-upon price (strike price) if the option is exercised. This strategy can generate income from the option premium and also provides the investor with the opportunity to purchase the underlying asset at a lower price than the current market value.
What is an Option Premium?
The option premium is the price that the investor receives for selling an option contract. It is the amount of money that the investor receives for selling the right to buy or sell the underlying asset at a specified price (strike price) by a specified date (expiration date). No matter if the price will increase or decrease, the seller will get the premium. One the strategy behind this method relies on accumulating the premium options without selling the stocks.
How to implement the Wheel Options Strategy
The Wheel Option Strategy involves creating a “wheel” of covered calls and cash-secured puts on multiple stocks. This allows the investor to generate income from multiple options premiums and potentially purchase stocks at a lower price. The goal is to generate income and potentially increase returns while managing risk by diversifying the portfolio across multiple stocks.
Step 1: Choose Stocks
The first step in implementing the Wheel Strategy is to choose the stocks that you want to include in your “wheel”. It is important to choose stocks that are of high quality and have a long-term track record of stability and growth.
Step 2: Determine Collateral
Once you have selected your stocks, you need to determine the amount of collateral that you will need to set aside for each stock. This will depend on the price of the stock and the strike price of the options contracts.
Step 3: Sell Covered Calls
The next step is to sell covered calls on the stocks that you have chosen. This will generate income in the form of the option premium. Choosing a strike price that is near the current market price of the stock will maximize the potential income from the option premium but will be riskier.
Step 4: Sell Cash-Secured Puts
The next step is to sell cash-secured puts on the same stocks that you have chosen. This will generate additional income from the option premium and provide the investor with the opportunity to purchase the underlying stock at a lower price if the option is exercised. When selling cash-secured puts, it is important to choose a strike price that is below the current market price of the stock.
Step 5: Monitor the Positions
Once you have sold both the covered calls and the cash-secured puts, it is important to regularly monitor the positions to ensure that they are performing as expected. This includes monitoring the stock price, the option premium, and the collateral.
Step 6: Adjust the Positions
If necessary, the investor can adjust the positions by buying back the options contracts or selling additional options contracts. This allows the investor to potentially capture additional income or manage risk as market conditions change.
Managing Risk with the Wheel Options Strategy
The Wheel Options strategy can be a useful tool for generating income and potentially increasing returns, but it is not without risk. Some of the key risks include:
- Stock price decline: If the stock price declines, the investor may have to sell their shares at a loss if the covered call is exercised.
- Exercise of the put option: If the put option is exercised, the investor may have to purchase the underlying stock at a higher price than the current market value.
- Volatility in the stock price: Volatility in the stock price can impact the option premiums and the value of the collateral.
To manage these risks, it is important to:
- Diversify the portfolio across multiple stocks to reduce the impact of any one stock’s performance.
- Regularly monitor the positions to ensure that they are performing as expected.
- Adjust the positions as necessary to capture additional income or manage risk.
How to Choose the Right Stock for the Wheel Strategy Options?
Selecting the right stocks is a critical component of the Wheel Options Strategy. Here are some steps you can follow to choose the right stocks for your portfolio:
- Consider Volatility: Look for stocks with low volatility, as these stocks tend to be less risky and less likely to experience sudden price changes. This can help reduce the risk of loss in your options positions.
- Evaluate Fundamentals: Review the fundamentals of each stock you’re considering, such as earnings, revenue, and debt. Stocks with strong fundamentals tend to be less risky and more predictable, making them better candidates for the “Wheel” strategy.
- Analyze Market Trends: Consider market trends and industry conditions when choosing stocks for the “Wheel” strategy. Look for industries that are growing and have positive outlooks, as these industries are more likely to provide stable and predictable returns.
- Monitor Earnings Releases: Keep an eye on earnings releases for the stocks you’re considering, as these events can have a big impact on stock prices. If a stock’s earnings fall short of expectations, it could result in a decrease in the stock price, which could negatively impact your options positions.
By following these steps, you can choose the right stocks for your “Wheel” strategy and increase your chances of success. Remember, it’s important to diversify your portfolio and not to put all your eggs in one basket. Consider spreading your investments across multiple stocks to reduce your exposure to risk.
Wheel Options Strategy Example
Here’s a simple example to explain the concept. Let’s say you own 100 shares of XYZ stock, which you bought for $100 per share. You are worried that the stock price might decrease, but you also want to earn some extra money.
With the “Wheel” strategy, you would sell a covered call option on your XYZ stock. This gives someone else the right to buy your 100 shares of XYZ stock for $110 per share. In return, you receive a premium, or payment, for selling this option. Let’s say you receive a premium of $100.
At the same time, you would also buy a cash secured put option on your XYZ stock. This gives you the right to sell your 100 shares of XYZ stock for $90 per share, no matter the current stock price. To secure the put option, you must have enough cash in your account, known as the collateral, to buy the shares if the stock price does go down to the put price.
Now, there are three possible outcomes:
- If the stock price of XYZ goes up: The person who bought the covered call option will exercise their right to purchase your 100 shares of XYZ for $110 per share. You would make a profit of $10 per share, plus the $100 premium you received for selling the covered call.
- If the stock price stays the same: The person who bought the covered call option will not exercise their right, and the cash secured put option will expire worthless. You would keep the $100 premium you received for selling the covered call.
- If the stock price goes down: You have the option to sell your 100 shares of XYZ for $90 per share, which is higher than the current stock price. You would make a profit of $10 per share, minus the cost of the cash secured put option, plus the $100 premium you received for selling the covered call.
In this way, the Wheel Strategy enables you to earn extra money through the premium received for selling covered calls, and protect your investment if the stock price decreases through the cash secured puts and the collateral in your account. It’s important to remember that options trading does come with risk, so it’s crucial to understand the risks involved and make informed decisions.
For more details, this video go through a more detailed example.
The Wheel Strategy can be a useful tool for generating income and potentially increasing returns for investors with a long-term investment horizon. By combining covered calls and cash-secured puts, the Wheel Strategy allows investors to generate income from multiple options premiums and potentially purchase stocks at a lower price. However, it is important to understand the risks and regularly monitor the positions to ensure that they are performing as expected.