Investing 101

Wheel Strategy: Generate Consistent Returns

Wheel Strategy: Generate Consistent Returns

The Wheel Strategy is an extremely powerful options trading strategy that allows you to profit from a single stock in four different ways, significantly increasing your overall long-term returns.

It is one of the best options strategies available, with lower risk and higher profitability than many other popular option strategies.

The Wheel Strategy is also an enhanced version of the traditional Buy&Hold strategy. It seeks to consistently invest in high-quality stocks or index funds ETFs while also collecting additional premium.

How It Works

The Wheel Strategy is a method for selling option cash-secured puts and covered calls in a systematic manner as part of a long-term trading strategy.

In essence, you continue to sell options on stocks in which you are bullish in order to generate monthly income.

The basic methodology is simple: 

  • you sell cash-secured put options on a stock until you are assigned and receive stock shares
  • you sell covered call options on the assigned stock until it is called away and you must sell the shares
  • you start over and repeat the cycle

Essentially, you sell cash-secured puts (CSP) repeatedly in order to collect option premium. If you are ever assigned, you must purchase the stock at the agreed-upon price. Then, while still holding the stock, you sell covered calls (CC) on it to earn more premium. When your stock is eventually called away, you must sell the shares and begin selling more cash-secured puts on the same or another stock.

 

The Wheel Strategy will pay you to open a long position, will allow you to collect dividends and benefit from stock price appreciation while holding the stock shares, and will then pay you to close the position.

1st Step

The overall process begins with the sale of a cash-secured put option on a stock and the collection of the associated premium. You should choose stocks that you are confident in buying at a specific price and holding for the long term. You must be willing and have the funds available to purchase 100 shares of the stock at the agreed strike price for each option contract sold.

There are two possible outcomes when the put option contract expires.

First Potential Outcome

The stock price is higher than the strike price. In this case, the option expires worthless, and you keep the entire premium you received when selling the option. Essentially, you are paid a premium to be able to purchase one of your favorite stocks at the agreed strike price on the option expiration date. Then you move on to look for new puts to sell.

Scenario

For example, Stock XYZ is trading at $100, and you sell one put option contract with a strike price of $95 and a time to expiration of 30 days, earning a total premium of $300 ($3.00 x 100). After 30 days, the stock is trading at $96, which is higher than the strike price. In this case, the option is worthless and you keep the entire $300 premium. Even if the stock price fell over the next 30 days, the trade was profitable. The outcome will be the same if the stock is trading at any price higher than the strike price at the time of expiration.

The second possible outcome is

The share price is less than the strike price. In this case, you must purchase 100 shares of the stock at the strike price for each option contract. That should not be a problem because you were bullish on the stock and are now purchasing it at a discount because the price is lower than when you sold the put option. In this case, you also keep the full premium you collected initially, lowering the stock’s overall cost basis.

 

Scenario

For example, suppose Stock XYZ is trading at $100, and you sell one put option contract with a strike price of $95 and a time to expiration of 30 days, earning a total premium of $300 ($3.00 x 100). After 30 days, the stock is trading at $94, which is less than the strike price. In this case, at expiration, you are assigned and must purchase 100 shares of the stock at the strike price of $95 even if the stock is currently trading at $94.

In this case, you also keep the entire $300 premium, which allows you to lower the stock price’s cost basis. Despite the fact that you purchased the stock at $95 (the strike price), the additional premium of $3 per share (obtained by selling the put option) allows you to reduce your overall cost basis to $92. So, if you decide to sell the stock at the current price of $94 per share, you will still make a $2 profit per share.

Scenario

For example, suppose Stock XYZ is trading at $100, and you sell one put option contract with a strike price of $95 and a time to expiration of 30 days, earning a total premium of $300 ($3.00 x 100). After 30 days, the stock is trading at $89, which is less than the strike price. In this case, at expiration, you are assigned and must purchase 100 shares of the stock at the strike price of $95 even if it is currently trading at $89. In this case, you also keep the entire $300 premium, which allows you to lower the stock price’s cost basis.

 

In any case, the additional premium of $3 per share (obtained by selling the put option) is insufficient to compensate for the stock’s price depreciation. This time, the overall cost basis of $92 is higher than the market price of $89, and if you sell the stock right away, you will lose $3 per share. You can, on the other hand, continue to hold the stock and wait for the trend to reverse to the upside. That should not be an issue because you were bullish on the stock when you sold the put option, unless some external events changed your overall sentiment about the stock.

 

If you believe the stock price will continue to fall, you can still sell the shares and take the loss. In any case, using the Wheel Strategy would result in a lower loss on the trade than if you had purchased the stock at the original price of $100. At the very least, the Wheel Strategy is an excellent method for lowering the overall cost of the stocks you want to buy anyway.

2nd Step

If you are assigned to a stock, you will sell an OTM (out-of-the-money) covered call with a strike price greater than the stock’s cost basis. If the price of the stock you now own rises but the covered call is not ITM (in-the-money) at expiration, you profit from the premium collected as well as capital gains over the entry price.

So, while holding the stock, you can generate a new source of income by selling covered calls multiple times for a higher premium, which will also lower the stock’s cost basis if all of these call options expire worthless. You keep doing it until the call option stock expires ITM, at which point the shares are called away from you.

Normally, you should avoid selling a covered call with a strike price that is lower than its cost basis, as this will result in a loss in the overall wheel trade. To determine this, you must keep track of all premiums received as well as stock appreciation.

There may be times when you are caught holding the underlying for an extended period of time until the uptrend resumes and you are back in a profitable range. This is why it’s critical to only invest in stocks and ETFs that you’re confident in long-term.

When the stock shares are called away from you, the Wheel Strategy cycle comes to an end.

If you trade dividend stocks, you may be able to capture some dividends as well. As a result, the Wheel Strategy can generate a quadruple source of income, as you should have collected option premium both selling cash-secured puts (before the stock was assigned) and covered calls (before the stock was called away) during the entire wheel cycle, plus any dividends while holding the shares and potentially some capital gains on the stock price.

Of course, it’s critical that you keep track of all the income generated in the various steps of each wheel trade, as you won’t be able to tell if the overall position is improving without this information.

Scenario

Assume Stock XYZ is trading at $100, and you sell a cash-secured put option contract with a strike price of $95 to earn a total premium of $300 ($3.00 x 100). The stock is currently trading at $96, which is higher than the strike price. In this case, the option expires worthless, and you keep the entire $3.00 per share premium.

You then sell a new put option on the same XYZ stock with a $90 strike price, earning a $2.00 premium per share. The stock is currently trading at $88, which is less than the strike price. You are assigned and must purchase 100 shares of stock at the agreed-upon price of $90 per share, even if the stock is trading below that level on the open market.

After the assignment, the stock continues to fall for a few weeks, and you sell a covered call with a strike price of $87, earning a $2.00 premium per share. The stock price is still $84 at expiration, so the option is worthless, and you keep the $2.00 premium per share.

You then sell a new covered call with a strike price of $86 and collect a $3.00 per share premium. The stock is trading at $87 at expiration, so the shares are called away, and you must sell them at the agreed strike price of $86 even if the stock is trading at a higher price on the open market. In this case, you also keep the entire premium.

You will also receive a dividend payment of $1.00 per share if you own XYZ stock.

So you received the following premiums as part of the overall wheel trade:

  • $3.00 per share for the first cash-secured put sale
  • $2.00 per share for the second cash-secured put sale
  • $2.00 per share for the sale of the first covered call
  • $3.00 per share for the sale of the second covered call; and
  • $1.00 per share in dividends for a total of $11.00 per share on this position.

In this example, you were assigned on the stock at $90, while the shares were called away at $86, resulting in a net loss of $4.00 per share. The total amount of premium collected, on the other hand, was able to offset the stock price depreciation, resulting in a net gain of $7.00 per share on the overall wheel trade.

Stock Picking

The main risk of the Wheel Strategy is in the stock or ETF position itself, because if the price falls, you will be forced to buy the shares at a loss when the put option is exercised. If the stock price continues to fall, you may be unable to sell a covered call with a strike price greater than the stock’s cost basis, and you will have to wait for the trend to reverse and the price to recover before the play becomes profitable.

As a result, the best candidates for the Wheel Strategy are primarily high-quality stocks with strong fundamentals or major stock market index ETFs such as SPY, QQQ, or DIA which we personally use here at 0SPX AutoTrades primarily with our 0-Gravity CFS Strategy. Indexes, and specifically their ETFs, work well because they are liquid, typically have low volatility, pay dividends, and tend to rise over time.

Stocks or ETFs that you do not want in your portfolio should never be considered. There may be times when you are unable to dispose of the underlying asset, and it may remain in our portfolio for some time. You don’t want to be forced to work in a job you despise. Choose only stocks or ETFs that you fundamentally understand and like, and that you believe will rise in value over time.

Because the power of the Wheel Strategy is in the time the options trader is willing to hold the stock or ETF like an investor until it returns to the entry price, you must be willing to own the underlying asset for the long term.

Conclusions

The Wheel Strategy is excellent for generating semi-passive steady income year after year, with lower risk than many other option strategies and typically outperforming the results of a simple Buy&Hold strategy.

In addition to stock appreciation, it seeks to lower the cost basis of your favorite stocks by collecting option premiums from the sale of cash-secured puts and covered calls, as well as dividend payments when possible.

In any case, this is not a get-rich-quick scheme that will make you a millionaire overnight. Forget about the day trading adrenaline as well. The Wheel is a methodical and frequently tedious strategy.

The Wheel Strategy will necessitate careful stock selection and a great deal of patience, but if executed correctly, it will generate regular and consistent returns month after month.

Personally, I prefer a consistent and reliable income over hypothetical and frequently improbable big wins.