How to Generate Consistent Returns with the Wheel Strategy

The Wheel Strategy is a really powerful options-trading strategy, that can allow you to profit from a single stock in four different ways, greatly enhancing your overall long-term returns.

It’s one of the best options strategies available, having relatively lower risk and higher profitability than many of the other popular option strategies out there.

The Wheel Strategy can be also considered as an improved version of the traditional Buy&Hold strategy. It looks to consistently invest in high-quality stocks or index fund ETFs and at the same time collect additional premium on top of it.


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How It Works

The Wheel Strategy is a systematic way to sell option cash-secured puts and covered calls as part of a long-term trading methodology.

In essence, you keep selling options on stocks that you are bullish on, to generate monthly income.

The basic methodology is very straight forward:
– you sell cash-secured put options on a stock until you get assigned and receive the stock shares
– you sell covered call options on the assigned stock until it is called away and you have to sell the shares
– you start again and repeat the cycle

Basically, you repeatedly sell cash-secured puts (CSP) to collect option premium. Should you ever get assigned you have to buy the stock at the agreed price. Then while holding the stock you sell covered calls (CC) on it to receive more premium. Once eventually your stock gets called away, you have to sell the shares and can start again going back to sell more cash-secured puts on the same or another stock.

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

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    Step #1

    The overall process starts selling a cash-secured put option on a stock and collecting the related premium. You should select stocks that you are confident to buy at a specific price, and eventually hold over the long term. For each option contract sold you need to be willing and have the funds available to purchase 100 shares of the stock at the agreed strike price.

    When the put option contract expires there are two possible outcomes.

    First Possible Outcome
    The stock price is above the strike price. In this case, the option expires worthless and you simply keep 100% of the premium you previously collected when selling the option. Basically, you get paid a premium to be available to buy one of your favorite stocks at the agreed strike price at the option expiration date. You then move on and look for new puts to sell.

    Example
    Stock XYZ is trading at $100 and you sell one put option contract with a $95 strike price, 30DTE (days-to-expiration), and collecting a total premium of $300 ($3.00 x 100). After 30 days the stock is trading at $96, so above the strike price. In this event, the option expires worthless and you keep the full $300 premium. The trade was profitable even if the stock went down in price over the 30 days. The result will be the same if the stock at expiration is trading at any price higher than the strike price.

    Second Possible Outcome
    The stock price is below the strike price. In this case for each option contract, you have to buy 100 shares of the stock at the strike price. That should not be a problem as you were bullish on the stock and you are now buying it at a discount, being the price lower than what it was when you sold the put option. Also in this case you keep the full premium you collected initially, reducing the overall cost basis of the stock.

    Example
    Stock XYZ is trading at $100 and you sell one put option contract with a $95 strike price, 30DTE (days-to-expiration), and collecting a total premium of $300 ($3.00 x 100). After 30 days the stock is trading at $94, so below the strike price. In this event at expiration, you get assigned and have to buy 100 shares of the stock at the strike of $95 even if it has a current market price of $94.
    Also in this case you keep the full $300 premium, and that allows to reduce the cost basis of the stock price. Despite you bought the stock at $95 (strike price) the additional premium of $3 per share (obtained selling the put option) allows reducing the overall cost basis to $92. So if you decide the sell the stock at the current price of $94 you will still end with a profit of $2 per share.

    Example
    Stock XYZ is trading at $100 and you sell one put option contract with a $95 strike price, 30DTE (days-to-expiration), and collecting a total premium of $300 ($3.00 x 100). After 30 days the stock is trading at $89, so below the strike price. In this event at expiration, you get assigned and have to buy 100 shares of the stock at the strike of $95 even if it has a current market price of $89. Also in this case you keep the full $300 premium, and that allows to reduce the cost basis of the stock price.
    Anyway in this case the additional premium of $3 per share (obtained selling the put option) doesn’t allow to offset the price depreciation of the stock. This time the overall cost basis of $92 is above the market price of $89, and if you decide to sell the stock right away you will end up with a loss of $3 per share. On the other hand, you can keep holding the stock and wait for the trend to reverse on the upside. As you were bullish on the stock (when you sold the put option) that should not be an issue, unless some external events changed your overall sentiment about the stock.
    If you think the stock price is going to keep sinking you still can sell the shares and take the loss. In any case, the loss on the trade would be lower using the Wheel Strategy than if you had bought the stock at the original price of $100. At the very least the Wheel Strategy is an excellent methodology to reduce the overall cost of the stocks you like and are looking to buy anyway.

    Step #2

    If you are assigned on a stock then you will look to sell an OTM (out-of-the-money) covered call with a strike price higher than its cost basis. If the stock that you now own goes higher in price but the covered call is not ITM (in-the-money) at expiration then you profit from the premium collected and capital gains over the entry price.

    So while holding the stock shares you can generate a new source of income by selling covered calls multiple times for more premium, which will also lower the cost basis of the stock in case all these call options expire worthless. You keep doing it until the call option stock goes ITM before expiration, and eventually, the shares get called away from you.

    Normally you want to avoid selling a covered call with a strike price lower than its cost basis, as that will bring a loss in the overall wheel trade. To ascertain that you need to keep track of all the premiums received plus the stock appreciation.

    There are times you could get caught holding the underlying for an extended period until the uptrend resumes and get back in a range of profitability. This is why it’s so crucial to only select stocks and ETFs that you are confident to own over the long run.

    The Wheel Strategy cycle ends when the stock shares are called away from you.

    If you trade dividend stocks you might hold the shares long enough to capture also some dividends. For this reason, the Wheel Strategy can generate a quadruple source of income, as through the entire wheel cycle 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), plus any dividends while holding the shares, plus potentially some capital gains on the stock price.

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

    Example
    Stock XYZ is trading at $100 and you sell a cash-secured put option contract with a $95 strike price collecting a total premium of $300 ($3.00 x 100). At expiration, the stock is trading at $96, so above the strike price. In this case, the option expires worthless and you keep the entire premium of $3.00 per share.

    You then sell a new put option on the same XYZ stock with a $90 strike price collecting this time a premium of $2.00 per share. At expiration the stock is trading at $88, so below the strike price. You get assigned and have to buy 100 shares of the stock at the agreed price of $90 per share even if the stock is trading in the open market below that level.

    After the assignment the stock keeps going down for a few weeks and while the price is at $84 you sell a covered call with a strike price of $87 collecting a premium of $2.00 per share. At expiration, the stock price is still $84 so the option expires worthless and you keep the premium of $2.00 per share.

    You then sell a new covered call with a $86 strike price collecting this time a $3.00 per share premium. At expiration, the stock is trading at $87 so the shares are called away and you have to sell them at the agreed strike price of $86 even if the stock is trading in the open market at a higher price. Also in this case you keep the full premium.

    While holding the XYZ stock you receive also a dividend payment of $1.00 per share.

    So during the overall wheel trade you received the following premiums:
    – $3.00 per share for the sale of the first cash-secured put
    – $2.00 per share for the sale of the second cash-secured put
    – $2.00 per share for the sale of the first covered call
    – $3.00 per share for the sale of the second covered call
    – $1.00 per share as dividends
    for a total on this position of $11.00 per share.

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

    Stock Selection

    The main risk of the Wheel Strategy is in the stock or ETF position itself as if the price plunges you will then buy the shares at a loss when the put option is assigned. Then if the stock price keeps going even lower you might not be able to sell a covered call with a strike price higher than the stock’s cost basis, and you would need to wait for the trend to reverse and the price to recover until the play become profitable.

    For this reason, the best candidates for the Wheel Strategy are mainly the highest quality stocks with strong fundamentals or major stock market index ETFs, like for example SPY, QQQ, or DIA. Indexes and more specifically their ETFs work well because they are liquid, usually have low volatility, pay dividends, and they tend to go up over the long term.

    You should never consider stocks or ETFs that you don’t want to have in your portfolio. There can be times when you are not able to get rid of the underlying asset, and it could sit in our portfolio for a while. You don’t want to be forced to hold a position you hate. Select only stocks or ETFs you understand and like fundamentally, and believe will move higher over the long-term.

    You must be willing to own the underlying asset for the long term, as 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 gets back to the entry price.

    Conclusions

    The Wheel Strategy is great for generating semi-passive steady income consistently throughout the year, with lower risk than many other option strategies, and usually widely exceeding the results of a simple Buy&Hold strategy.

    On top of stock appreciation it looks to reduce the cost basis of your favorite stocks by collecting option premiums from the sale of cash-secured puts and covered calls, and when possible also dividend payments.

    Anyway, this is not a get-quick rich scheme that will make you millions overnight. Forget also the day trading adrenaline. The Wheel is a methodical and often boring strategy.

    The Wheel Strategy will require proper stock selection and a lot of patience, but if done right will generate regular and consistent returns, month after month.

    Personally, I prefer a steady and reliable income, instead of hypothetical and often improbable big wins.


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