In this article, I will explain in very simple and plain terms what exactly is the wheel strategy and how you can make consistent monthly income following this strategy.
My goal is to put it in such a way that any beginner can understand and implement this easily. If you are completely new to options trading then you should first read through the options 101 beginners guide first. That will provide you with the basic ins and outs of options trading.
So without further delay let’s jump right into the article.
What is the wheel strategy?
This is one of the safest options strategies that you can find in the market. This primarily involves 2 legs that consist of selling cash-secured puts (CSP) and selling covered calls ( CC). It starts with the first leg of selling a cash-secured put on a stock that you want to own at a certain price.
You then keep selling puts until assigned and once assigned you then start selling covered calls against the same stock until it gets called away. That completes a full circle and you start again from the beginning by selling puts. In all of this, you collect a premium at every step plus any capital gain on the stock that you get when your stocks are called away.
Overall it is a Win-Win strategy from all sides as long as you follow a few things and run the wheel on good stock.
What are cash-secured puts?
Cash secured put is leg 1 of the wheel strategy. ( Refer to the yellow box in the diagram below) In very simple terms you basically agree to buy 100 shares of a stock at a certain price only if it hits that price on the day of option expiration. For this, you put money equal to the purchase price of 100 stocks as collateral and in exchange for that, you get to keep the premium.
What is the covered call strategy?
This is leg 2 of the wheel strategy ( Refer to the yellow box in the diagram below). This is exactly the opposite of Cash secured put. Once you have 100 shares of stock assigned you to sell a covered call against that. In simple terms, you agree to sell 100 shares of a stock at a certain price only if it hits that price on the day of option expiration. For this, you put your 100 shares as collateral and in exchange for that, you get to keep the premium.
As you can see you get to keep the premium no matter what.
Now let’s understand the steps of the wheel with an example
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Let’s take a concrete example from the Robinhood platform to understand this strategy. The price of Google Stock as of the writing of this article is about $96 and you want to run the wheel on it.
- The first step is to sell a cash-secured put on Google. You first select Sell/Put from the top and select expiry as a week in advance. You then select $95 as your strike price. For this, you will get a premium of about $158 and you have to put $9500 as collateral.
2. At expiry, if the Google stock closes above your strike price of $95. Your collateral money is released and you also get to keep all the premiums.
3. You repeat step 1 of selling CSP again next week and collect the premium. You keep doing this until the Google stock closes below your strike price of $95.
4. Stock Assignment – If Google closes below your strike price you are required to buy the Google stock at the strike price of $95. As a result of this, you now own 100 shares of Google at $95 for each stock.
5. Now you turn the wheel and start selling covered calls against the stock. You pick the strike price let’s say $97 and select the expiry of the week ahead. You get a premium of $161.
6. You keep repeating step 5 of the selling covered call until Google stock closes above your stick price of $97.
7. Stock Called Away – If the stock closes above your strike price of $97 you have to sell your shares. However, you will have a $200 profit from the stock since you bought it at $95. Plus you get to keep the premium.
How to select the best stock for wheel strategy
- Liquidity is very important when selecting any stock options and the same applies to the wheel strategy. You need to ensure that there is a good amount of volume for the stock you plan to do wheel strategy.
- Run the wheel strategy on a stock that you really like to own in your portfolio.
- Avoid stocks with high volatility, they tend to have high price swings which are not what you want to run the wheel strategy.
- Consider selecting stock with a low beta value. This is another indicator that you can use to avoid high swings stocks.
- Take advantage of the Bollinger band indicator to identify stocks that are mostly range bound. It’s preferred to have a stock that doesn’t is range bound.
- Use this site to find a good liquid and active option to run a successful wheel strategy.
FAQ
The wheel strategy consists primarily of two options legs. It starts by selling a cash-secured put and collecting a premium on that until the stocks are assigned. Once the stocks are assigned you start selling the covered call against those stocks and collect premium until the stocks are called away. And the cycle or wheel counties again from cash-secured put.
The wheel strategy is a consistent way to generate income from the stock market. Unlike simply buying call options or put options that are considered risky, the wheel strategy is way less risky and at the same time highly profitable.
There are certain factors that you will have to watch out for when choosing stocks for the wheel strategy, they are liquidity, low volatility, and stability. The range-bound stocks are considered the best to run wheel options. One of the main technical indicators that you can leverage to select the stocks for wheel strategy is the Bollinger bands. That gives you a good view of entry and exit values.
We can take the example of Google stock. let’s assume the stock is trading at $110, you start selling a cash-secured put at the strike price of $105 until you are assigned and then you start selling a covered call with a strike price of $120 until stocks are called away. That completes one full cycle of the wheel and it restarts again.
Wheel strategy is one of the options strategies that consists of two option legs, cash-secured puts, and covered calls. You start by selling cash-secured puts until stocks are assigned and then do a covered call until stocks are called away.
