Today, we’re going to break down a popular options trading strategy known as the “wheel strategy”. It’s a straightforward, yet effective strategy that is perfect for beginners and seasoned traders alike. Remember, the world of options trading can be complex, but with patience and a clear understanding, you can successfully navigate it.
Before we jump into the strategy, let’s refresh your understanding of options. Options are contracts that give you the right, but not the obligation, to buy or sell an underlying asset at a set price before a specific date. A ‘call’ option gives you the right to buy, and a ‘put’ option gives you the right to sell. Got it? Great, let’s continue.
The Wheel Strategy – An Overview
The wheel strategy is a three-part process that involves selling puts until you get assigned shares, then selling calls until the shares get called away. It’s called the “wheel strategy” because it’s a cycle that can be repeated indefinitely, like a spinning wheel.
This strategy provides consistent income from the premiums you collect, but it’s crucial to only use it on stocks you’re comfortable owning for the long term. Remember, in the world of options, you are not just buying or selling an asset, you’re also buying or selling the risk associated with that asset.
Step One: Sell a Cash-Secured Put
To kickstart the wheel strategy, you first sell a cash-secured put. This means you sell a put option on a stock you’d like to own and receive a premium for it. The put is “cash-secured” because you have enough cash in your account to buy the stock if it falls below the strike price and gets assigned to you.
The premium received from selling the put is yours to keep, no matter what happens. If the stock price stays above the strike price, the put option expires worthless, and you’ve made a profit from the premium. If the stock price falls below the strike price, you’re obligated to buy the stock at the strike price, which might be higher than the current market price. But remember, you should only sell puts on stocks you’re comfortable owning.
Step Two: Get Assigned the Stock
If the stock price drops below the strike price, you’ll have to buy the stock at the agreed-upon strike price. While this might seem like a loss, don’t worry. You were already comfortable owning the stock, and now you do, potentially at a lower price than when you sold the put.
Additionally, you still keep the premium you received from selling the put. This premium can offset the potential loss you’ve incurred because you bought the stock at a higher price than its current market value. In fact, your actual cost basis for the stock is the strike price minus the premium received.
Step Three: Sell a Covered Call
Now that you own the stock, it’s time to sell a ‘covered call’. When you sell a call, you’re giving someone else the right to buy your stock at a set price before a specific date, and you get paid a premium for it. It’s ‘covered’ because you own the stock you’re selling the call on.
The premium you receive is yours to keep, regardless of what happens next. If the stock’s price stays below the strike price, the call expires worthless, you keep the premium, and you still own the stock. If the stock’s price rises above the strike price, your stock will be sold at the strike price. The premium you received can add to your profits or offset potential losses if the stock was sold at a lower price than its current market value.
Rinse and Repeat
And there you have it, the wheel strategy. Once your stock has been called away, you can start the process all over again. Rinse and repeat, like a wheel turning around its axle.
Some Considerations
While the wheel strategy has its advantages, such as generating consistent income and potentially owning a stock you like at a lower price, there are some risks involved. The market could fall significantly, leaving you with a stock that’s worth much less than what you paid for it. Or the stock could skyrocket after you’ve sold a call, and you’d miss out on those potential gains because you’re obligated to sell the stock at the strike price. It’s essential to always consider these risks and only sell options on stocks you’re willing to own for a long time.
Moreover, the wheel strategy requires a fair amount of capital, as you need to be able to buy the underlying stock if assigned. It also needs close monitoring and might not be suitable for every investor.
The wheel strategy can be a rewarding way to engage with the market, offering an additional income stream while giving you the potential opportunity to buy stocks you like at lower prices. It’s a practical method to deepen your involvement with options and add a new dimension to your investment strategies. As with any investment, understanding the process and the risk involved is key to success. Always remember, the wise investor is an informed investor.
So, are you ready to take this wheel for a spin? The options market awaits you!
