Wheel

The Wheel Strategy: A Guide to Selling Cash-Secured Puts and Covered Calls

The Wheel Strategy is a simple yet effective options trading method that combines selling cash-secured puts and selling covered calls to generate consistent income from your investments. It’s particularly appealing for investors who are comfortable owning the underlying stock.

What Is the Wheel Strategy?

The Wheel Strategy involves three main steps:

1. Sell Cash-Secured Puts: Earn premium by selling put options on a stock you’re willing to own.
2. Buy the Stock (If Assigned): If the stock price falls below the strike price, you’ll buy the stock at the strike price, effectively getting it at a discount.
3. Sell Covered Calls: Once you own the stock, sell call options on it to generate additional income.

You repeat this process in a “wheel” until you no longer wish to trade the stock.

Step 1: Selling Cash-Secured Puts

• What It Is: Selling a put option obligates you to buy the underlying stock at the strike price if the option is exercised.
• Why Cash-Secured? You set aside enough cash to purchase the stock if assigned, reducing risk.

How It Works:

1. Choose a stock you’d like to own.
2. Sell a put option at a strike price below the current stock price (your desired buy price).
3. Collect the premium upfront.

Key Considerations:

• Strike Price: Select a price you’re comfortable paying for the stock.
• Expiration Date: Choose a date far enough out to collect meaningful premium but not so far that your capital is tied up too long (1-4 weeks is common).
• Premium Yield: Calculate the yield:
  Premium Yield = (Premium Collected / Cash Secured) × 100%

Possible Outcomes:

1. Stock Price Stays Above the Strike Price:
   • The put expires worthless, and you keep the premium.
   • Repeat by selling another cash-secured put.
2. Stock Price Falls Below the Strike Price:
   • You’re assigned the stock and must buy it at the strike price.
   • You effectively purchase the stock at a discount (strike price minus the premium).

Step 2: Owning the Stock

Once assigned, you own the stock. Now, your goal shifts to generating income by selling covered calls.

Advantages of Owning the Stock:

• You acquire shares of a company you wanted at a price you were comfortable with.
• You can now collect dividends (if applicable) in addition to selling covered calls.

Step 3: Selling Covered Calls

• What It Is: Selling a call option obligates you to sell your stock at the strike price if the option is exercised.
• Why Covered? The stock you own “covers” the obligation, reducing risk.

How It Works:

1. Sell a call option at a strike price above the current stock price (your desired sell price).
2. Collect the premium upfront.

Key Considerations:

• Strike Price: Choose a price you’re happy selling the stock for (typically 5-10% above the current price).
• Expiration Date: Select a date that balances premium collection and risk of assignment (1-4 weeks is common).
• Premium Yield: Calculate the yield:
  Premium Yield = (Premium Collected / Stock Value) × 100%

Possible Outcomes:

1. Stock Price Stays Below the Strike Price:
   • The call expires worthless, and you keep the premium.
   • Repeat by selling another covered call.
2. Stock Price Exceeds the Strike Price:
   • The stock is called away (sold at the strike price).
   • You realize a profit:
     Profit = Strike Price – Purchase Price + Premium Collected
   • Repeat by selling cash-secured puts to start the cycle again.

Example of the Wheel Strategy

Step 1: Sell a Cash-Secured Put

• Stock: XYZ
• Current Price: $50
• Strike Price: $47
• Premium: $1.50
• Cash Secured: $4,700
• Possible Outcomes:
  1. Stock stays above $47: Keep $150 premium.
  2. Stock falls below $47: Buy 100 shares at $47, with an effective cost basis of $45.50 (strike price – premium).

Step 2: Sell a Covered Call

• Stock: XYZ (100 shares)
• Current Price: $46
• Strike Price: $50
• Premium: $2.00
• Possible Outcomes:
  1. Stock stays below $50: Keep $200 premium.
  2. Stock rises above $50: Sell stock at $50, earning:
     ($50 – $45.50) × 100 shares + $200 premium = $700 profit.

Benefits of the Wheel Strategy

1. Steady Income: Generate consistent premiums by selling options.
2. Lower Risk: The strategy revolves around stocks you’re willing to own.
3. Discounted Entry: Cash-secured puts let you acquire stock at a discount.
4. Double Income: Covered calls add another layer of income once you own the stock.

Risks of the Wheel Strategy

1. Stock Price Decline: If the stock’s price drops significantly, you may incur losses despite collecting premiums.
2. Stock Called Away: If the stock price rises sharply, your upside is capped at the call strike price.
3. Capital Requirements: Cash-secured puts and covered calls require substantial capital, especially for high-priced stocks.

Tips for Successful Wheel Trading

1. Choose Quality Stocks: Focus on stable, dividend-paying companies you’d be happy to own.
2. Manage Strike Prices: Select strike prices that align with your investment goals and risk tolerance.
3. Avoid Overpricing: Don’t chase high premiums for risky stocks with volatile prices.
4. Diversify: Spread the strategy across multiple stocks to reduce risk.

Conclusion

The Wheel Strategy is a powerful way to generate income while systematically building or trading around a stock portfolio. By selling cash-secured puts and covered calls, you can earn regular premiums, lower your cost basis, and potentially realize capital gains. With patience and proper risk management, the Wheel can be an excellent strategy for investors seeking consistent returns.