Three Things to Know About the Wheel Strategy

The wheel strategy is a popular options strategy that involves selling cash-secured puts on a stock, buying shares of the stock if the option is assigned, and then selling covered calls on the underlying asset until it is called away. If the strategy works out, a trader can potentially repeat it again and again, riding a wheel that can generate income in sideways or bullish markets.

It's not a sure-fire money machine, however. The wheel strategy has risks traders need to manage. If the options are too close to being in the money (ITM) or market volatility increases, traders could end up buying the stock above market value or selling it below. Choosing fundamentally sound stocks at reasonable strike prices is crucial because traders must be comfortable owning the shares if the price declines and the put is assigned. Misjudging the choice of the underlying asset and the strike price can expose traders to downside risk.

By combining responsible options trading with careful stock selection, effective risk management, and patience, though, the wheel trade can be an attractive options income strategy. Here are three things to know about the wheel strategy.

The wheel strategy has a few different steps, and each one calls for a bit of analysis. It's basic enough for a beginning trader who is willing to do a little research in pursuit of passive income by collecting options premiums. At any experience level, traders must pay attention to what they're doing when they choose the underlying stock and the options that go with it.

• Step 1: Sell out-of-the-money (OTM) cash-secured put options and collect the premium on an underlying stock that a trader would be willing to own but seems a bit expensive. The put will typically have a relatively close expiration (six months or less) and be OTM. The further OTM, the lower the premium may be and the less likely the option will be exercised. With a secured put, a trader keeps enough cash on hand to buy the stock, should the option be assigned.
• Step 2: If the puts are exercised, and the cash in the account is used to buy the shares, go to Step 3. If the option is not exercised, a trader can keep the premium, then go back to Step 1 and write another option with a new expiration date and strike price.
• Step 3: Write covered calls on the stock and collect the premium. The calls will typically have a relatively close expiration (six months or less) and be OTM. If a trader sees significant upside potential in the stock, then the call is generally very far OTM. The closer it is to being ITM, the higher the premium, and the more likely the option is to be exercised.
• Step 4: If the call option is exercised, sell the stock to the new owner and go back to Step 1. If not, keep the premium and write another covered call option as in Step 3 to collect additional premium.

By repeating the options wheel strategy, a trader may be able to build a strategy to supplement the income of an income-focused portfolio or perhaps increase the return on an equity-focused portfolio.

When the wheel strategy works, traders generate premium income that offsets the purchase price of an attractive stock, and then adds it to the profit earned from holding that stock. When the strategy fails, the premium income doesn't offset losses on a stock that was purchased at a low price and then falls even lower.

A wheel strategy starts with identifying a stock that has a positive outlook but seems to be overvalued. This involves looking at things like its earnings, stock ratings, and valuations to form an opinion about the company's value. Ideally, the put is assigned on a day where the market is weak, potentially allowing the trader to acquire the shares of a quality company at a lower price than when the put was initially sold. Unfortunately, some people trying the options wheel strategy end up being assigned shares in a troubled company that continues falling after the put option has been exercised.

The next part of setting up a wheel strategy trade is selecting strike prices for the options. The closer an option is to being ITM, the higher the options premium—and the more likely it is to be exercised. Traders seeking to maximize their income need to compare that to the strike prices where they would be most interested in buying and selling the shares. The options that generate the most income could result in losses on the equity position. For example, a trader could end up acquiring shares above the current market price when a put is exercised, and then have the shares called away before the price recovers.

The wheel strategy is supposed to be income-generating. If the options are far enough OTM that the risk of exercise is low, then the premium for writing them will be small too. A call option with a higher strike price will have a lower premium, and that additional income isn't worth the time and risk to some traders.

The wheel strategy is mildly bullish. In up market conditions, a trader could conceivably write OTM puts, profitably, for a long time. After being assigned, the trader could then hold the stock and collect dividends as the stock price increases. Writing call options that provide premiums could eventually result in the stock being called away, but with a capital gain. With good trade management and smooth market conditions, wheel trading can generate income for traders with a lower risk tolerance.

In a down market, or if the underlying stock and chosen strike prices do not work out as expected, the wheel strategy takes on more significant risk. Price movements in a volatile stock market could lead to unexpected put assignment, leaving the trader stuck with an asset that has a falling share price.

First, the secured put that starts a wheel trade may increase in value because the stock's fundamentals have changed for the worse. After assignment, the trader is stuck with shares that continue to fall in value, unless they're sold at a loss.

Second, as with any options income strategy, a trader can potentially maximize premium income by shorting calls and puts that are near the money. The more likely that an option is to be exercised, the higher the option's price. A trader could end up buying stocks above market value on the put side and selling them below market value on the call side.

Finally, the wheel trade relies on cash-secured puts, which tie up a trader's cash balance. When interest rates are low, the interest earned on the cash balance may be negligible, even with the additional income earned from the options premiums from both the puts and the calls. That represents an opportunity cost.

Some traders looking for income consider the wheel strategy—but do so carefully. With good trade management and attention to fundamentals, it can potentially be a rolling wheel of income and capital gains if the strategy works out.