The Wheel Strategy Options: Does this option strategy makes sense?

Is the Options Wheel Strategy the holy grail of passive income investing?

The wheel strategy is an options strategy that is based on the notion of option selling. For those who are not familiar with options, option selling is a very common strategy used to generate income.

Unlike stocks where selling short a stock (stock you do not already own) might be prohibitive and subjective to borrowing cost, selling an option contract is undertaken with ease and, in fact, more popular than buying an option contract. Why is that so?

This is because selling an option contract entails the seller receiving an income right from the onset. Who does not like receiving money right from Day 1?  

Let me break down The Wheel Strategy into 4 steps for a better illustration.

Step 1: Selling a Cash-Secured Puts option on a stock

This is the first step of the options wheel strategy where a trader sells a cash-secured put option on a stock. As a put option seller, he/she is entitled to receive a premium aka income right from the start but is now obligated to buy the shares if the price falls below the strike price of the option.

Sounds complicated? Let me illustrate this concept with an example.

Say for example you like to own Apple shares, at the current market price of $139/share. This stock price is slightly more than what you would be comfortable paying, say at $130/share.

Instead of waiting for Apple shares to decline to $130/share before buying them outright, what an options trader can do is sell a put option with a strike price of $130/share, expiring in 45 days-time.

As a seller of an option, he/she receives a premium, in this case, approx. $290/options contract. That translates to an ROI of 2.2% a month or 26.7% annualized return.

The Put option seller now has an obligation to buy Apple shares when the current market price drops below $130/share within the 45 days contract horizon. If the stock price remains above $130/share at the end of the 45-day contract horizon, the put option contract expires worthless and he/she pockets the full $290 premium.

Key points to note when selling put options

The stock should typically be one where the downside risk is low in the first place and not some random stocks that you hear from Reddit traders, for example.

1. The put option contract should be cash-secured. This means that you have enough capital to own at least 100 shares of Apple for $130/share. This translates to $13,000 in account size to sell 1 Cash-secured Put option contract.

2. Very often, platforms provide margin facilities for an option seller such that the capital required to sell an option is a fraction (say 20%) of the cash-secured puts amount. This also depends on the strike price of the option contract being sold.

Many newbie option traders get into trouble because they tend to sell more contracts that are way more than the cash secured put amount. For example, 5 put option contracts of Apple at a strike price of $130 translates to a cash-secured amount of $65,000. One should have a capital of $65,000 before attempting to sell 5 put option contracts on Apple.

3. Ideally, the implied volatility of the stock should be high to benefit from theta decay as an option seller. This can be represented by the counter’s implied volatility rank (IVR). I won’t get into details of IV/IVR in this article but one should not engage in put option selling when the IVR of the counter is less than 20%, in my view.

4. The lower the strike price of the put option sold vs. the underlying price (which currently stands at $139/share), the lesser the premium received. This is because there is now more margin of safety (MOS).

Say for example, instead of selling a put option contract at a strike of $130, one sells it at a lower strike of $120. The premium received in this case is $135/contract but there is now greater MOS for the put seller. The price of Apple will need to drop to $120/share vs. the earlier example of $130/share before he/she is obligated to take ownership of the stock aka buy the shares for $120.

Step 2: Put option expire worthless or you get assigned the stock

There are 2 scenarios in Step 2.

Scenario 1

On the expiration date (45 days later in this example), the share price of Apple is > $130/share. The put option contract that was sold expires Out-of-the-money (OTM). This means that it is worthless and as a put seller, this is what you wish to happen. You have effectively sold the option at $290/contract and are now buying back to close off the contract at $0/contract.

You can now continue the put-selling cycle by selling another cash-secured put option on Apple at your preferred strike price and generate another round of income.

The downside of a cash-secured put selling strategy is that if Apple price rallies, say to $160/share, one will not be able to partake on the upside since the maximum profit entitled to the put seller is the premium received.

The most ideal scenario for the put seller is one where the share price of Apple closes just slightly above its strike price of $130/share on expiration. This will allow the put seller to either generate more premium in its next round of put selling at the same strike of $130/share or to lower its put option strike price to say $120/share, which can be viewed as an even more “value purchase”.

Scenario 2

This is when on expiration, the price of Apple drops below the strike price of $130, say at $125/share. In this case, the put option seller will now be obligated to purchase (at least 100 shares of) Apple at the strike price of $130/share vs. the current underlying price of $125/share being transacted in the market.

This means that the unrealized loss is now $5/share ($130 cost price – $125 market price). However, the earlier premium of $2.90/share helps offset this loss amount such that the current unrealized loss in this example is $2.10/share.

One will now need to fork out $130 * 100 shares = $13,000 for each put option contract sold (since 1 contract represents 100 shares). As earlier mentioned, to make this strategy a safer one, it should be on a cash-secured basis where one has $13,000 capital to take ownership of 100 shares of Apple.

One will also need to be comfortable in purchasing Apple and holding onto this counter if the share price decline of Apple is rather drastic and reduces the impact of Step 3 of the options wheel strategy.

Step 3: Sell an OTM call option on the stock which you get assigned to

If you get assigned the counter in Step 2, thus taking ownership of the stock, you can then sell another options contract, this time around, a call option contract (vs. selling a put option contract in step 1).

Selling a call option contract is a “bearish” strategy, one where you engage if you don’t think the share price of a counter will trend higher. Hence, you are effectively “short” the counter.  

However, if the share price does move higher and in certain cases substantially, the losses can be rather large. Therefore, a naked call option selling strategy is often seen as a “high risk” strategy and should not be engaged by newbie option traders.

By combining a long stock position with a sell call, one is essentially structuring a covered call strategy which turns a highly risky naked call selling trade into a relatively a safe option strategy.

This is because when the underlying share price appreciates, the long position in your stocks will fully offset the losses from your sell call position. When the price declines, your stock loses value but that is partially offset by the gain in your sell call position (which increases in value when the price declines)

Say you took ownership of Apple at $130/share as the current underlying price is now $125/share on expiration. After accounting for the earlier put premium of $2.90/share that you received, your breakeven is now $127.10/share.

You decide to sell an Out-of-the-money (OTM) call option contract at a strike of $130/share for 30 days to generate a round of premium that will reduce your breakeven cost even further.

Let’s assume that one will be able to generate a premium of $210/contract by selling a call option at a strike of $130 for 30 days. The breakeven is now reduced to $127.10 – $2.10 = $125/share.

Step 4: Stock gets called away or continue selling call option

Scenario 1

If Apple’s price appreciates beyond $130/share on the expiration date (in 30 days), you are now obligated to sell 100 Apple shares at $130/share. Since you already own 100 Apple shares from Step 2, this would be sold off, leaving you with no outstanding position.

Your overall profit potential is $130 sale price – $130 cost price + $2.90 premium from sell put + $2.10 premium from sell call = $5/share or $500 for 100 shares.

You have now exited the options wheel strategy, realizing a profit of $5/share or $500/contract in this example.

Scenario 2

If Apple shares remain below $130 on contract expiration in 30 days, your call option contract expires worthless. You continue to own 100 shares of Apple and you can now sell another round of call options to generate your next leg of premium. The premium generated will goes toward further lowering your breakeven price (which currently stands at $125/share)

The ideal scenario would be one where the price of Apple is slightly below your sell call strike of $130/share on expiration. This will allow you to generate a higher premium in your next round of sell calls at the same strike price of $130 or allow you to shift your strike price higher to $135/share to increase your profit potential.

Let say for example Apple’s price ends at $129/share on your sell call contract expiration (after 30 days). Your sell call option expires worthless and you continue to be the proud owner of Apple share, now with a breakeven of $125/share.

You decide to sell another call option, expiring in 30 days, with a new strike of $135/share, generating a premium of $150/contract. Your new breakeven is now $125-$1.5 = $123.5/share.

Apple’s price continues to appreciate from hereon and after another 30 days, it is now trading at $140/share. Your sell call option is now In-the-money (ITM) and you are now obligated to sell your 100 Apple shares for $135/share, thus fully exiting your option wheel strategy trade.

Total profits = $135 sale price – $123.5 breakeven price = $11.50/share or $1,150 for 100 Apple shares.

You have now completed your option wheel strategy in this 4-step process. While it might look like a solid option strategy to execute on the surface to generate income on stocks that you are comfortable in owning, there are a few risks that I will like to highlight.    

Main risks associated with the Option Wheel Strategy            

1.Over-leveraging

I highlighted in Step 1 that this strategy should be executed on a Cash-Secured basis and one should have sufficient capital to take ownership of the stock in question when the underlying price falls below the Sell Put strike price.

However, many traders tend to overlook this critical factor and end up selling more contracts than they can truly afford. When an assignment happens, they realize that they do not have sufficient capital to take ownership of the shares and thus must close realize the losses immediately.

2.Selling call options below the breakeven price

My earlier example highlighted a scenario where the share price decline of Apple in Step 2/3 is not significant which allows one to sell a call option at a strike price higher than one’s breakeven level.

However, let say, for example, Apple’s share price declined to $115/share and you are forced to take ownership of its shares at $130/share.

Your breakeven level from the first round of put selling generating $2.90/share is $127.10. Selling a 30 days call option at a strike of $130 entails negligible premium and thus some might be “forced” to sell a call option at a strike of $120/share.

Assume this sell call generates a premium of $2.10, thus reducing your overall breakeven price to $125.

When Apple’s share price appreciates to $125/share after 30 days, your Sell call at strike $120 is now ITM and you are obligated to sell your shares at $120/share.

Total loss = $125 breakeven price – $120 sale price = $5/share in losses.           

3.Wrong selection of stock  

While most proponents of this strategy will recommend executing on stocks that you “don’t mind to own” in the first place, a better selection would be to execute the options wheel strategy on stocks with limited downside risk.

This is because for a low downside risk counter, even if the put option seller becomes obligated to take ownership of a stock, he/she can still sell a call option (Step 3) above the breakeven level with relative ease.

A volatile growth stock that you don’t mind owning in the first place might witness a substantial drawdown in its share price such that Step 4 of this strategy is no longer appropriate aka, no longer able to sell a call option above the breakeven price to generate any meaningful amount of income.

In such a case, you might be “stuck” with a stock that you might have to hold for an undefined period or be forced to cut loss as the prospect of the counter appreciating beyond your breakeven level is now extremely low, even if one has the intention to hold for the long-term.

4.Selling put options on low IVR stocks

As an option seller, it will be ideal to sell options (either put or call) on stocks whereby their Implied Volatility Rank (IVR) is high.

This is where the effect of theta decay will be the strongest and most beneficial for an option seller.

I will look to be selling options only on counters where their IVR is above 20%.  Ideally, this ratio should be > 50% but such a criterion will reduce the pool of potential candidates for put option selling drastically.

If a stock has a low IVR rank, the risk of put option selling could be a subsequent rise in IVR. Such a scenario makes the early exit (before expiration) of a sell put more challenging.

This is however a lower risk factor vs. the other risks factors highlighted in this segment.   

Conclusion

The option wheel strategy is great for generating semi-passive income consistently through the year. The right selection of stock (one with low downside risk) for the options wheel strategy will allow you to outperform the typical buy and hold strategy.

My preferred plays for this strategy are typically the more defensive counters which pay a dividend, for example, a stock like Philip Morris (PM).

Such a stock has a 1) low downside risk of a substantial collapse in share price which will render the subsequent call option selling ineffective and 2) get to benefit from dividends paid by the counter when I do take ownership of the stock.

Of course, if you do already have a stock in mind which you believe has good long-term appreciation potential, then you can enter into this option wheel strategy trade with an investing mindset.

Do note, however, that such a stock might be overvalued in the first place which could result in a substantial drawdown in its share price. You are thus forced to take ownership of the counter at an elevated price level and hold onto this counter for a prolonged period.

This would make the call option selling (step 3) portion a difficult one to execute as selling a call option below your breakeven price might result in a premature sale at a loss when the price illustrates a quick rebound.

An alternative might be to execute on a basket of stocks through an ETF which reduces the company-specific risk associated with an individual stock counter and thus also the scenario of an unforeseen substantial price decline.

The Wheel Strategy is not a get-rich-quick strategy that will generate 1000% returns for you but one that if executed properly could result in a stream of consistent passive income for you.     

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