What Is the Wheel Strategy?
The Wheel Strategy for options trading is one of the more consistent ways to make income through collecting premiums. Before discussing an options trading strategy, it will probably help to go over some of the basics. I never want to assume that every investor knows how to trade options contracts. In this article, we will discuss some fairly advanced options terminology, so I want to start off by making sure we’re all on the same page!
What Is an Options Contract?
An options contract is a financial contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a previously agreed upon price and date.
There are two types of options contracts: calls and puts. In the simplest terms, a call option gives the right to buy an asset and a put option gives the right to sell an asset.
Many traders think that calls are bullish and puts are bearish.
The great thing about options is that they can be either. Sometimes call options can be bearish and sometimes put options can be bullish. I won’t go into those details here but you’ll see a bit of this explanation in the Wheel Strategy.
What Is a Strike Price?
The strike price for an options contract is the agreed upon price at which the option can be exercised. Strike prices can be in the money or out of the money.
For call options, in the money would refer to being below the current market price, while for puts, in the money would be above the current market price. The opposite applies for out of the money strike prices.
The strike price is a critical factor in determining the intrinsic value of the contract. Further out of the money strike prices are obviously less likely to be successful, and therefore cost less in terms of premium.
What Is the Premium in Options?
The premium refers to the actual market value of the options contract. This is the cost of buying an options contract and the income made when selling one. Many options traders can make a consistent income flow based on selling premiums on contracts.
The premium is also the main source of profit in the Wheel Strategy, as well as other options strategies like the Covered Call.
What Is the Wheel Strategy Expiration Date?
The expiration date of the options contract is the date at which the contract must be exercised.
The holder of the contract can exercise the contract anytime before the expiration date if it falls on the correct side of the strike price.
At the expiration date, the owner must either let the contract expire worthless, exercise the contract, or get assigned the underlying shares.
The further out an expiration date is, the higher the premium as a general rule of thumb. The closer the expiration date is, the lower the premium.
What Are the Greeks?
The Greeks are terms you will often hear in relation to options trading. They refer to specific variables that have a direct effect on the premium and value of the contract.
The Greeks are Delta, Theta, Gamma, Vega, and Rho. There are also some minor Greeks as well like lambda, epsilon, vomma, vera, speed, zomma, color, and ultima.
I won’t go into too much detail here but I recommend learning the basics of the Greeks before getting into options trading.
What Is the Wheel Strategy?
The Wheel Strategy for options trading is a cyclical process that provides consistent income via collecting premiums.
There are three specific steps to the Wheel Strategy, but for the most part, staying in Step 1 is optimal.
As with most options strategies, the key to executing the Wheel Strategy is choosing the right stocks.
You don’t want stocks with too much volatility that can fall below the strike price during a bad session.
Let’s take a closer look at the three steps in the Wheel Strategy.
Wheel Strategy Step 1: Selling Put Option Contracts
When it comes to options, I find most traders are confused about put options. Call options are easier to understand. Instinctively we always think stocks will rise in the future, so the mechanism behind calls is fairly simple.
Most people think that put options contracts are bearish. While this is true when you buy a put contract, when you sell one it can actually be bullish.
Remember, when you sell an option you are collecting a premium on it. There is another trader that is buying that contract from you and paying the premium. When you sell a put option contract, you believe that the stock price will stay above the strike price.
This means that until the expiration date of the contract, you are betting that the stock will perform well. Rinse and repeat this step for as long as possible to continue to collect premium. But sooner or later you will likely come to Step 2 in the Wheel Strategy.
Wheel Strategy Step 2: Get Assigned Shares
What does it mean to get assigned shares? It means when you were selling put contracts in Step 1, the price of the stock dipped below the strike price at the expiration date.
This means you are on the hook for buying the shares of the underlying stock. Remember, each option contract is a block of 100 shares. If you sold five put options contracts, you’d have to buy 500 shares of the stock.
This is why you should always make sure you have enough buying power when selling puts. If you do get assigned, you will want to be able to afford to buy those shares. It might seem like a major blow to be assigned shares, but there is a silver lining. This brings us to Step 3 of the Wheel Strategy.
Step 3: Sell Covered Calls on Your Assigned Shares
That’s right! It’s time to make more premium on the shares you were assigned! Selling covered calls means you are selling call options on a position you hold. The goal for selling covered calls is that the stock price does not rise above the strike price.
Either way, covered calls are a desirable outcome. You can either continue to sell covered calls for premium or sell the shares back at some point to recuperate your money.
What happens if you get assigned when selling covered calls? In this scenario you actually sell off your shares. This is why it is a ‘covered’ call.
Once you’ve either assigned your shares or straight up sell them back to the market, you can head back to Step 1 again. Now you can see why this is called the Wheel Strategy.
Does the Wheel Strategy Work?
The Wheel Strategy is one of the more sound and consistent options strategies to use. Since each step has a positive outcome, no matter what happens, a lot of options traders like to use it to stabilize their portfolio.
Traders can stay at Step 1 of the Wheel Strategy for years if they choose to. The key for this is to not be greedy, and focus on choosing a lower strike price, rather than aiming for a higher premium. If you continue to choose higher premium contracts, the chances of you getting assigned becomes more likely.
The one thing about the Wheel Strategy you should note is that it does need a fairly sizable account balance to start using it. Since you are always at risk of being assigned shares, you need to make sure you have adequate buying power.
It also helps to use a margin account to increase your total buying power. I don’t normally suggest you trade on margin, but for a solid options strategy like the Wheel Strategy, it comes with a bit of a safer floor.
The Wheel Strategy isn’t the fastest way to make money, but it is consistent. Warren Buffett himself has been known to sell put options on his held positions to increase income flow. Buffett then reinvests this into the positions he holds.
Selling put options isn’t normally what new options traders go for, but I can assure you it is an excellent way to make steady income. In times of market volatility like we are currently experiencing, this additional cash flow can go a long way in stabilizing your account.
The Wheel Strategy is an excellent way to make income off of premium for your account. If things go awry, there is always a benefit to taking the next step in the strategy. This strategy likely won’t make you a millionaire, but it can provide you with enough consistent cash flow to build a strong portfolio. If you didn’t want to read through the article, here is the TL:DR:
- Sell Put Options on a stock
- Get Assigned those shares
- Sell Covered Calls on those shares
- RInse and Repeat
It’s a very simple system that is effective. The only thing you really need to learn is which stocks to pick. Also, it helps to have as much buying power as possible in case you do get assigned. Hope this helped! If you want to learn more about options, make sure to sign up for our options courses online.