Category: Beginner Investing 101

In the world of financial markets and the wealth management sphere, the options wheel strategy stands out for its potential to generate cash flow on a consistent basis. This strategy is ideal for those who are new to options trading, and for retirees who want to generate regular cash flow on their portfolio, perhaps from blue-chip dividend stocks.

In this guide to the options wheel strategy, we will dive deep into the intricacies, covering essential components such as covered calls and cash-secured puts, and how to potentially enhance your returns with dividends.

Understanding the Basics

Before we dive into the mechanics of the wheel strategy, let’s establish a brief foundational understanding of options trading. Options are financial derivatives that give buyers the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (strike price) before a specified date (expiration date).

As an example, let’s assume that you are interested in buying XYZ stock, but you don’t actually want to put up all of the money to purchase XYZ stock at the moment. You are looking to buy 100 shares of XYZ, but it is trading at $100 per share, which means you would need to give up $10,000 to purchase your 100 shares.

In this case, if you were perhaps on the fence about rather or not you wanted to fork $10,000 over to buy all 100 shares, you could instead buy a call option while you make your final decision, which would give you the right, but not the obligation, to buy XYZ stock at an agreed upon price, which is $100 per share in this case. On the other side of this trade, you have the seller of the option, who is interested in collecting a premium, and is hoping in the process that XYZ stock stays below $100 per share.

In a nutshell, this is how options trading works. For more information on options trading for beginners, check out this resource. Additionally, keep in mind that with the options wheel strategy, we will not be buying options, but rather selling them.

The Wheel Strategy Overview

The wheel strategy is a systematic approach that involves three main steps: selling cash-secured puts until you get assigned the stock, and then turning around and selling covered calls until the stock is called away. This strategy is designed to generate regular income through the premiums that are generated when you sell the options, in a repeating “wheel” like fashion (over and over again).

In some cases, which we will discuss several paragraphs from now, you can even possibly collect dividends while implementing this strategy, perhaps against a portfolio of dividend aristocrats.

Step 1: Selling Cash-Secured Puts

The journey begins with selling puts on a stock you would be happy to own at a certain price. This is done by choosing a stock with a solid fundamental outlook, and that falls in line with your risk tolerance and investment objectives.

It also involves choosing a price that you would feel comfortable owning the stock at, and many times this strategy is completed by purchasing a stock at a discount to the current market price. The put option you sell then gives the buyer of the option the right (but not the obligation) to sell the stock to you at the strike price, and in return, you collect a premium for doing so.

The “cash-secured” part means that you have set aside enough cash to purchase the stock if the option is exercised. For example, if you sell a put option with a strike price of $100, you need to have $10,000 in your account, as you’re committing to buy 100 shares at $100 each if the option is exercised. The premium for selling the option on this $10,000 in collateral, is to compensate for the potential risk that by the expiration day, the stock price could fall below the strike price.

For example, if XYZ stock is currently trading at $103, and you decide to sell a $100 put option with an expiration date one month out (let’s say March 15th, since today is February 15th), then you would collect a premium, and in this case, we will say the premium you receive from selling the put option is $300.

However, this $300 premium is to compensate for the potential risk that come the expiration date of March 15, the stock price may have fallen below the strike price of $100, perhaps to $95, $90 or even lower. Either way, you would collect the premium for selling the option, and be on the hook for purchasing the 100 shares at the $100 strike price.

This is why it is typically better to perform the wheel strategy against stocks that are lower overall in terms of their beta and volatility profile, such as blue chip dividend stocks.

Step 2: Holding and Collecting Dividends

If the stock price drops below the strike price before the expiration day and your put option is exercised, you would then end up buying the stock at the strike price. Once you own the stock, you can benefit from any dividends it pays, which would add an additional income stream to your portfolio. Selecting dividend-paying stocks, therefore, instead of stocks that do not pay dividends, can add an additional layer of effectiveness when it comes to maximizing cash flow from wheel strategy.

Step 3: Selling Covered Calls

After acquiring the stock, the next phase is to sell covered call options. A covered call involves selling a call option on a stock you already own. This gives someone else the right to buy your shares at an agreed upon price (once again, the strike price) within a specified time period.

As with selling puts, you collect a premium for selling the call option. Typically, the strike price on the option you sell, will be of an equivalent or greater price than of the cash secured put option that you sold.

This is to ensure that you don’t end up selling your shares for a loss, and worst case, if you were to perhaps sell a cash secured put at $100, and then turn around and sell a covered call at $100, you would break even on your shares, even if both options are exercised. Thus, you collect both premiums in the process, and come out ahead either way.

To summarize, the goal for the covered call trade would be to set the strike price equal to, or above the value of the strike price for the put option you sold, with the main focus of ensuring that you always receive a premium (or cash flow) in the process.

Integrating Dividends for Maximum Cash Flow

Including dividend-paying stocks in your wheel strategy can potentially further increase the amount of cash flow you receive. When selecting stocks, consider those with a consistent dividend payout and a history of financial stability. Dividends can provide a regular income source while you own the stock, which complements the premiums collected from selling options.

The key when attempting to collect dividends and implement the wheel strategy, is to consider both the ex-dividend day of the stock (must own the stock one day before the ex-day to receive the dividend), and the expiration day of the covered call option that you sell. With American style options, for example, the buyer of the option can technically exercise the option any time before expiration.

Therefore, if you sell an XYZ covered call for a March 15th expiration, and the stock is trading at $105 with two weeks to expiration, the buyer of the option may very well send your broker an exercise notice, and you would be on the hook for selling your shares at the agreed upon strike price. However, if you owned the stock one day before the ex-dividend date or sooner, you would still receive the dividend, even if your shares get “called away” and the dividend has not actually been paid yet.

This makes for an interesting situation, as there are many factors to consider in terms of implementing cash secured puts, covered calls and dividends combined, but if you perform this strategically and with intent, it can be done in some cases, which can help you to obtain additional cash flow from your portfolio.

Risk Management and Considerations

While the wheel strategy can generate regular income, it is not without risks. Key considerations include:

• Stock Selection: Ensure you choose stocks you are comfortable holding long term. Market downturns can leave you holding stocks for longer than anticipated.
• Volatility: High volatility can often result in increased option premiums due to the higher implied volatility, but also the risk of significant stock price movements.
• Assignment Risk: Be prepared for the possibility of assignment at any step, which can impact your cash flow and investment strategy.
• Capital Requirement: Cash-secured puts often require significant capital up front, which is equivalent to the amount of shares you are purchasing (in 100 share increments), and you must be prepared to purchase the stock if assigned at the strike price.

Tips for Success

1. Start Small: Consider starting with stocks that require less capital, which means you won’t have to put up as much money to begin with. For example, instead of XYZ stock at $100 per share, consider ABC stock at $20 per share, especially if you are brand new to this strategy, and don’t want to risk a lot of money.
2. Stay Informed: Keep on top of market trends, along with company-specific news even, that can impact stock prices.
3. Diversify: Don’t rely on a single stock or sector and ensure you build a well-diversified portfolio to mitigate risk.
4. Patience: The wheel strategy is a marathon, not a sprint. Consistency and patience are key to realizing its benefits.

Conclusion

The options wheel strategy offers a structured approach to generating regular cash flow, through a combination of option premiums (and potentially dividends if you choose to implement the strategy this way). By carefully selecting stocks to purchase and managing risks effectively, you can potentially enjoy a steady income stream. Remember, while the wheel strategy can be rewarding, it’s essential to understand the risks involved and proceed with caution while remaining in line with your specific investment goals and objectives.