What Is The Wheel Trading Strategy?

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What is the wheel strategy?

The wheel strategy is when you sell an out-of-the-money put. If that set option expires in the money, you take an assignment of that stock and sell out-of-the-money call options. 

If that call option becomes in the money, the long stock/shares will get called away from you, closing the position. 

To summarize:

  1. Sell an out-of-the-money put
  2. If that position expires in the money, then you take an assignment
  3. Sell an out-of-the-money call 
  4. Continuously sell out of the money calls until the work is called away from you.

What are the pros of the wheel strategy?

The wheel strategy’s first benefit is its relatively low risk. 

It is low risk because you are selling an out-of-the-money put option, so the stock would have to fall below its current market price. 

Then, you are further reducing your risk by selling out of the money call options to reduce your basis and collect more premiums. 

The second advantage of the wheel strategy is that it provides you with a win rate of over 50%.

A relatively high win rate is significant if you want to become a successful and profitable trader. 

Another advantage is that you can participate in the stock’s upside if assigned the shares. 

This works out exceptionally well if a stock is oversold and then begins going up again. By being long the shares, you can participate in the upside. 

The final significant advantage of the wheel strategy is rarely mentioned. 

When you are a long stock, you will not be adversely affected by the volatility expansion inherent in options during a significant sell-off. 

As a result, if you sell a relatively far-out-of-the-money put option and it gets assigned to you, you won’t have to deal with the buying power reduction inherent during a significant volatility expansion event because equities do not have a volatility component. 

What are the disadvantages of the wheel strategy?

The first disadvantage is that the wheel strategy could be more capital efficient because you will be long stock.  

The second disadvantage is that the wheel strategy has a lower win rate than selling out-of-the-money put options and rolling and managing positions (compared to taking stock ownership when running the wheel). 

When you run the wheel option trading strategy, your win rate will be over 50%, but when you sell an out-of-the-money put or call option, your win rate can be around 95%.

Your win rate on the wheel strategy will be 60% to 65%. However, your win rate when you sell an out-of-the-money put option can be over 95%. 

The third disadvantage is that your upside participation for owning the stock is capped by the strike price selection for the call option you’re selling. 

As a result, you’re unable to fully realize the stock’s upside potential because your profits will be capped by the call option you sell. 

The fourth disadvantage of the wheel strategy builds off the first disadvantage. The buying power reduction for stocks is around 50% when you use regulation T, but the buying power reduction when you sell out of the money put options is only about 15% or 20%. 

As a result, the buying power you will use by being a long stock can be about 2.5x to 3x more than when you sell an out-of-the-money put option. 

The final disadvantage to the wheel strategy is that during a prolonged bear market, you will lose money, dollar for dollar, by being a long stock instead of when you sell options. 

When you sell options, you can roll down the strike price by about $5 or $10 by rolling it out in time, and you can often improve the basis of your strike price by reducing the strike price by ~20% – 30%. It’s common for you to spend around $2 or $3 to realize an incremental $5 or $10 in strike price improvement and reduction of the strike price of your put option – and that $2 or $3 can easily be captured by simply rolling out the vote in time and extending duration. 

You can allocate the time premium to decrease the strike price on your put option by about $5 or $10. However, you must realize this benefit when running the wheel strategy (because there is no expiration component when long stock). 

For every dollar the stock decreases in value when you are long shares, you will experience a $100 decrease in your net liquidation value for every contract you sell. 

Remember that one contract represents 100 shares of stock. If you are a long stock and that supply decreases by $1, then your net liquidation value will fall by $100, or the full extent of the decline in that underlying stock. 

However, if you’re selling options, you can reduce that strike price by about $5 or $10 simply by rolling forward that option in time.

Simultaneously, it will be a more efficient transaction because, being short, the options will use up about two and a half to three times less buying power than being long the stock. 

One of the problems of running the wheel strategy in a bear market is that you will take assignments of a lot of stocks, which will use a lot of your buying power. 

The amount of premium you will collect by selling the call options is not even close to the amount of losses you will suffer in a bear market by being long all those shares of stock. 

Should you use the wheel strategy? 

David Jaffee believes the wheel strategy is good because it gives you a win rate of about 60% to 65%. 

However, David Jaffee does not use the wheel strategy because taking stock ownership is not capital efficient. 

Additionally, you will lose a lot of money during a bear market by running the wheel strategy. The losses that you are going to suffer during a protracted bear market are not going to be able to be offset by selling call options. 

When you roll options, you can realize a significant improvement to your strike price by simply using the premium you would receive from moving it forward and allocating that towards improving the strike price. 

You can allocate that time premium towards your strike price to decrease the put option by about $5 to $10. You will only pay about $2, and you’ll be able to finance that $2 by simply rolling forward that option a few weeks out. 

However, you need that advantage if you are running the wheel strategy. For every $1 the underlying stock falls, you will realize a relatively significant decrease in your overall P&L. 

Wheel strategy is worthwhile and relatively safe for people to implement.

Conclusion:

The options wheel strategy is an advanced option play best suited to experienced investors with a solid knowledge of the options market. Though this particular strategy may be too technical for less-experienced options traders, the beauty of the options market is that there is something for everyone. Whether your view is bullish, bearish, or even neutral, you can profit using options at risk levels that suit your financial situation.

Frequently Asked Questions (Wheel Strategy):

What are some other resources about the Wheel Strategy?

This is a good article about the wheel strategy.

What are the typical wheel strategy returns?

What are the best stocks for wheel strategy?

Usually, the best stocks for the wheel are stable companies with solid brands where you can sell far OTM call options while capitalizing on the underlying stock's price appreciation.

What is the option wheel strategy?

The wheel strategy is a long-term strategy that allows investors to systematically obtain stock at a discount (using Cash Secured Puts) and, in the event of getting assigned, purchase the store at the short put strike and start selling Covered Calls to generate additional income.

How do you trade options wheel strategy?

The wheel strategy is a long-term strategy that allows investors to systematically obtain stock at a discount (using Cash Secured Puts) and, in the event of getting assigned, purchase the store at the short put strike and start selling Covered Calls to generate additional income.

Is the wheel strategy profitable?

However, it could be more capital efficient, and the covered call limits your upside potential profits.

What is the most profitable option strategy?

Selling out-of-the-money options is the most profitable option strategy.

What is the safest option strategy?

Selling out of the money put options is the safest strategy (as long as you have enough buying power to take ownership of the stock).

Can you make millions trading options?

Yes, you can make millions trading options, but it requires a lot of discipline & knowledge.

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