In this article, we’ll cover a popular income-generating options strategy called the option wheel. This strategy – which is intended to generate consistent income by collecting continuous premiums – is a combination of two other options trading strategies: the cash-secured put and the covered call.
But first, some context
In previous articles, we’ve covered put options, which give holders the right to sell 100 shares of an underlying security at a specified strike price, and call options, which instead give holders the right to buy 100 shares at a set price.
The cash-secured put and covered call are strategies for selling put and call options.
When you sell a put option, you’re agreeing to buy 100 shares of a company at the strike price by the expiry date. In exchange for this agreement, you’re paid a premium. Your objective is for the put option to expire worthless, so that you don’t need to purchase the shares; however, it won’t always work out this way. If your put option is cash-secured, this simply means that you have enough money in your account to purchase the shares at the strike price, in case you need to. (Technically, the wheel strategy does not require you to sell put options that are cash-secured, but many investors prefer this added layer of protection.)
When you sell a call option, you’re agreeing to sell 100 shares of a company at the strike price by the expiry date. As with selling a put option, you’re paid a premium for making the deal, and your objective is for it to expire worthless. Using the covered call option strategy means purchasing the 100 shares in advance. This way, in the event your option is assigned and you’re forced to sell, you already have the shares in your account. This protects you from having to first buy the shares at a much higher price. In other words, you’re ‘covered.’
How the wheel strategy works
The wheel strategy has two main steps, with two possible outcomes for each step.
Step 1: Sell a put option, and collect the premium.
- Outcome 1: The stock price stays above the strike price, and the put option expires worthless. This is the desired outcome. In this case, repeat step 1.
Outcome 2: The put option is assigned, and you must buy 100 shares of the option’s underlying stock at the strike price. In this case, proceed to step 2.
Step 2: Sell a call option (with the same underlying stock), and collect a premium. Thanks to your newly acquired shares, you’ll be using the covered call strategy.
- Outcome 1: The stock price stays below the strike price, and the call option expires worthless. In this case, repeat step 2.
- Outcome 2: The call option is assigned, and you must sell 100 shares of the option’s underlying stock at the strike price. In this case, go back to step 1.
It’s called the wheel strategy because it never stops. Simply repeat steps 1 and 2 continuously for consistent income. That’s the goal.
But there are some additional considerations. With any option contract, the investor has to make a series of choices. Which underlying should they select? How much higher or lower than the current price is the strike price? And how far away is the expiration date? Each choice has its own pros and cons, depending on what your objectives are.
Choosing an underlying stock
You can pick anything! But throwing a dart at a dartboard may not be in your best interest.
Remember, you’ll likely end up buying 100 shares of this company at some point. So, it makes sense to select a stock that you’re comfortable with owning. This probably means picking a stock that you think will bounce back consistently; even if this stock falls in value, you’re pretty sure it will recover over time.
However, there’s a downside to picking a stock that’s too stable: the premium. If you select a stock that’s extremely stable and sees little to no movement over long stretches of time, you’re unlikely to receive any meaningful premium for selling an option. Because of this, some wheel strategy enthusiasts will select stocks that have high volatility. This gives them access to higher premiums, but it also creates more risk that their options will be assigned. Tradeoffs, tradeoffs…
Choosing a strike price
Remember, your best-case scenario is that the option expires worthless. So, when selling your put option (step 1), you might be tempted to pick a strike price extremely far away. But, if your strike price is too much lower than the current stock price, you’ll receive little to no premium.
There’s a fine line to strike here (see what we did there?). Ideally, you want to pick a strike price that you don’t think your stock will reach, so that the option is never assigned. At the same time, you want to pick a price that you’d be comfortable purchasing your stock at; this is also why you want to select an underlying stock that you believe will recover.
When it comes to selling call options (step 2), some investors want to avoid losing money on the underlying stock, so they’ll ensure that their strike price is at least as high as their purchase price. But this may not always be possible, especially if your stock has fallen sharply, as picking a higher strike price for your call option may result in little to no premium.
Choosing an expiration date
By now, you’ve probably spotted a trend: ‘safer’ decisions tend to result in lower premiums. When it comes to picking an expiration date, this pattern holds. If your expiration date is further away, there’s more time for the price to move against you; as a result, you’ll likely receive a higher premium.
A closer expiration date will generally mean a lower premium – but this doesn’t necessarily mean less income in the long run. Shorter contracts give you the ability to keep the wheel moving. Sure, you’ll be earning less premium per contract, but you’ll also be cycling between contracts more quickly, generating income as you go.
Understanding the risks
Sharp price movements are the enemy of the wheel strategy.
If your stock declines sharply during step 1, you’ll have to purchase 100 shares at your strike price and hold those shares at a much lower price. If you’ve chosen a stock you believe will recover, this may not sound so bad. But, remember, your next step is to sell a covered call. You may want to sell the call at a strike price close to your purchase price. But because the stock price has fallen so drastically, it’s unlikely that you’ll be able to do this while still making a decent premium.
In this situation, you’re left with three options:
- Pause the wheel. Delay selling the call until you’re able to get a decent premium at a strike price near your purchase price. The risk, of course, is that your stock may never recover, and it could even decrease further.
- Sell a call at a lower strike price. This keeps the wheel going, but if the stock price increases sharply, you’ll have your shares called away at a much lower price. In this case, you’ll likely accept a loss on your stock position.
- Sell a call with a later expiration date. This might increase your premium, but it will also slow the pace of the wheel strategy. You’ll sell fewer options throughout the year, so you’ll likely generate less income overall.
Summary
The wheel strategy involves choosing a single underlying stock and cycling between selling a put option and selling a call option. The put option may require you to purchase 100 shares of the stock, and the call option may require you to sell them. All the while, you’ll receive consistent income through premiums – as long as sharp price movements don’t lead to losses instead.
