The Wheel Options Strategy
By: Jerry Ng
Tags: Options Trading, Stocks, Options, Investing, Stock Market

Why? Why? Why?

Photo by Emily Morter on Unsplash

While the strategy of investing consistently into something like an index fund (or index ETF) is great, I want to do better.

By utilizing The Wheel, one can attempt to mimic that strategy by collecting premiums on top of it.

Generally speaking, there are mainly two reasons that The Wheel can be viewed as an improved version of the Buy and Hold strategy:

It reduces the cost basis of your favorite stocks (strongly prefer index ETFs) It collects option premium on top of stock appreciation (if stock is assigned)

The Wheel is a great strategy for generating semi-passive income with a lower risk than many other option strategies.

In my humble opinion, using this strategy on an index ETF is necessarily no riskier than buying and holding an index ETF.

Here are some of my favorite ETFs to wheel with:

Strategy

The Wheel Strategy Flow Chart

Like many other things in the world, there are multiple versions of the same strategy out there. For starters, here are some of the relatively conservative tips or setup of The Wheel that one can use:

One must be willing to hold the underlying for the long term (!!!)

Look for major Index ETFs (i.e. SPY, QQQ, ARKK, etc.)

(i.e. SPY, QQQ, ARKK, etc.) Sell contracts that have about 30 — 45 Days to Expiration ( DTE) as it offers a good premium as the time decay curve start to accelerate

Days to Expiration ( as it offers a good premium as the time decay curve start to accelerate Look for contracts that have a 70% probability of being Out of the Money (OTM) or roughly 0.30 Delta

If you are assigned a stock, sell a covered call with a strike price higher than its cost basis

a Take profit at 50% return or 21 DTE

One thing to note is that one might prefer wheeling SPY over VOO due to SPY’s significantly larger trading volume which implies a better bid-ask spread.

Adjusting and Customizing

Once you’re familiar with the strategy, you can then tweak the strategy according to your risk tolerance, such as — wheeling an individual stock, selling At The Money (ATM) puts, selling options at a shorter DTE, and more.

You could aim further OTM if you want to be more conservative; aim closer ATM to be more aggressive. Though, selling OTM for both ends of The Wheel might not be a bad idea as it can give you downside protection from drops while also giving you upside protection from rallies.

Remember, if you aren’t willing to buy and hold the underlying while selling a covered call, look elsewhere.

Profit Taking

The general idea here is to take profits at 50%. This will tend to yield greater $/day returns if the underlying is moving in your direction.

For instance, think about this — if you make a 50% return in 10 days out of a 45 days contract, it makes little sense to hold another 35 days for another 50% premium gain. To avoid time risk, simply close the position and collect the secured premium to release collateral for another sell.

On top of that closing short positions at 50% profit has been shown to increase the probability of profit and overall P&L compared to holding to expiration when backtested by TastyTrade.

Avoiding Assignment (arguable)

Some versions of The Wheel strategy argue that one should always avoid assignment by selling CSP over and over again or rolled for credit to avoid assignment. It argues that the goal of The Wheel strategy is to collect the premium, and not be assigned stock.

On the other hand, there are counter-argument about this — if we are bullish on stock or ETF for the long term, we shouldn’t have any problem accepting stock ownership. As a matter of fact, our returns might be increased due to stock appreciation on top of option premium gain.

I’ll leave it up to you to decide.

Downside

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Capital Intensive

To start The Wheel on major index ETFs such as SPY or QQQ is extremely capital intensive for most of us.

At the time of writing this, the price of QQQ is $300 which implies that you will need a sum of $30,000 to start wheeling. I know what you might be thinking — margin. I’ll explain it a bit more later on.

Steep Price Drop

The biggest risk of this strategy is when puts have been sold on a stock that goes down a lot in price. The worst-case scenario is that we will be forced to buy a stock at the strike price after it has fallen well below that strike price in the open market — hence we must be willing to own the stock for the long term in the first place.

This also means that if the underlying is moving against you, you generally want to hold until expiration and collect 100% of the premium. However, this is no more risk than just owning the stock outright.

Having that said, it might be a good idea to not trade more than about 5% to 10% of your buying power in any one stock to avoid news or movement from the stock from blowing up your account. It is also a good idea to keep 50% of your buying power available for safety and to take advantage of any market dips.

Caveats

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Thinking This Will Make You Rich Quick

This is not as sexy or as exciting as trading. It is boring.

If you think that you’ll get a quick fantastic return out of this — you’re wrong. This strategy would require proper stock and patience to result in steady and reliable income, hence — index ETFs.

Using Margin

Technically one could utilize margin to do The Wheel to maximize return or increase the size of your trade. Though, one should not advocate such a strategy especially if you are inexperienced as it might blow up your account on a single bad trade while also running the risk of a margin call.

Be Wary of High IV Stocks

If you tend to wheel smaller ETFs such as XLF, you may notice that your returns aren’t that great. It’s plain and boring but it’s safer.

On the other hand, while wheeling some of the high IV stocks can yield better returns, you need to note that they have high IV for very good reasons — their prices are subjected to high volatility of change. It works until it doesn’t.

I’d prefer to stick with more stable stock with a solid balance sheet and strong fundamentals, or just major index ETFs.

Closing Thoughts

You need to note that these strategies should only be used as general guidelines. Tweak and find a strategy that fits your risk appetite and improvise accordingly and you’ll find success. Always, always remember to manage your risks and constantly be aware of them and never be complacent.

Another good note, while you’re running The Wheel, is that you might want to consult your tax consultant as it might be a lot less tax-friendly than regular buy and hold depending on where you are from.

There are more resources out there where they have done some pretty good backtesting on The Wheel. Read them up. Having a tracking sheet to track your P&L might be a good idea if your broker doesn’t provide you a good way of tracking it.

I hope you learn something new today, good luck!