Trading options doesn’t have to be rocket science. It doesn’t have to be risky either. We already know that selling options is way safer than buying them. In fact, we know that selling options gives us over an 80% chance of winning all of our trades.
But what do we do if the option we sold goes into the money?
There’s an interesting strategy that can easily fix our losing short option. It’s called the wheel strategy. When you wheel, you attack the trade from all around, hence why it is called ”the wheel”.
After reading this post, you will understand how to use the wheel strategy to avoid taking losses. Let’s dive into how to use the wheel strategy.
What Is The Wheel Strategy?
The wheel strategy is an interesting way to work yourself out of a losing position.
The wheel strategy is an option strategy that a lot of traders enjoy using because it lets you collect a steady stream of incoming. The best part is you get to decide when you get paid! You can choose to get paid weekly, monthly, quarterly, or yearly. It’s not too far fetched to earn 3% a year. That’s 36% annualized! You can’t get returns that easily anywhere else!
So how do you use the wheel strategy? Well, let me show you the way!
How To Use The Wheel Strategy
Using the wheel strategy requires you to attack a trade from all angles. You will be a short seller and a buyer. You must be comfortable shorting options and owing shares of a stock to use this strategy.
Enough talking about it, let me show you how to use the wheel strategy. Let’s look at the first step of the wheel strategy, which is to sell a cash secured put!
Step One: Select A Bullish Stock
The wheel strategy works best on stocks that you’re super bullish on and can afford to own 100 shares of. A good candidate would be a stock that is fundamentally strong. You want to see strong earnings, profit/revenue growth, low debt, etc.
A strong stock that you’re confident is going to keep growing over time is perfect to use for the wheel. Keep in mind that timing the stock‘s growth isn’t important for this strategy and you will eventually see why.
Another important thing to look for is implied volatility (IV). This part is entirely up to you and your risk tolerance. If you want a relatively safe stock that does not have frequent price swings, look for a stock with low IV. 30% IV is usually considered safe. The trade off is that you will be receiving a much smaller premium for each contract that you sell.
The average IV is around 40% to 65%. You will usually find these IV levels in growth stocks, such as in the tech sector. These stocks usually offer a decent premium for each contract you sell. I usually sell options for such stocks.
If you have a huge appetite for risk and are looking for big rewards, you can shoot for IV levels of 85% and above. Just remember that these stocks will have violent price swings.
Step Two: Sell A Put To Start The Wheel Strategy
When you’re bullish you sell a put. Now you just need to figure out the strike and expiration of the put you are going to sell to start using the wheel strategy.
Choosing The Strike
Most traders prefer to choose the last level of support as their strike to sell. You can sell the strike of the most recent support and feel relatively safe about the option expiring out-of-the-money.
A more aggressive approach is to sell a strike that is in-the-money. You should only do this if you are confident that the stock will be at or above that strike at expiration. This approach requires using advanced technical analysis techniques such as patterns and indicators.
Choosing The Expiration Date
You can choose the expiration date by using the same principles discussed in general options selling. The idea is the same- pick an expiration date that is not too far out, but not too close, that way you can collect the perfect amount of premium.
Far out expirations offer the highest amount of premium, but you will have to hold onto them for a long time before you start seeing any profits. This is because theta decay isn’t much until the option reaches the last two months of its life.
With that being said, picking an option with about 45 days until expiration will let the profits pile up more quickly. Theta decay begins to accelerate fastest at 45 days until expiration.
Step Three: Wait Until Expiration
Expiration day is where all the fun is. If you’re using the wheel strategy, you do not have to even bother checking on your position until expiration (unless there is horrible news that changes the bullish outlook for the stock).
At expiration there are only two possibilities- you’re option is either out-of-the-money or it is in-the-money. What you do next depends on where your option is.
What To Do If Your Option Is Out-Of-The-Money
Get ready, this part is super exciting! Ready for it? Okay, here it is:
Let your contract expire and go back to step one to start the process over again. Congratulations, you avoided assignment!
What To Do If Your Option Is In-The-Money
Don’t go and start panicking. Everyone seems to panic here because they think being in-the-money is a guaranteed loss. Well guess what, it’s not. Just let the option expire and then we will have more fun with the stock.
Yes, letting the contract expire in-the-money means that you have to take on assignment of 100 shares of the stock. Why does that idea bother you? Aren’t you bullish on the stock?
Now that you have 100 shares of the stock, you basically start at step one again, but instead of selling puts, you’re selling calls.
Step Four: Selling Covered Calls To Complete The Wheel
Owning 100 shares of a stock allows you to sell covered calls. When you sell puts, your collateral is the amount of cash necessary to buy 100 shares. When you sell calls, your collateral is the 100 shares that you won.
If the call you sell goes in-the-money, you have to sell your 100 shares at the strike price. This tells you that you must sell calls at or above your trade price (which is the strike of the put you originally sold, minus the premium collected).
You sell a call at or above your cost basis so that you can walk away at either break-even or with a profit in the case that your shares get called away (i.e., you call expires in-the-money).
If you’re super lucky and don’t get your shares called away as the stock rises, you can just keep selling calls. In this case, you’re making double the profits! You’re collection money from the call premium and you’re collecting money from the shares appreciating in value.
Wow…. who would’ve thought that being assigned shares would be so lucrative!
When Your Shares Get Called Away The Wheel Strategy Is Complete
Congratulations! You have just completed the wheel! You just played the stock all the way around. Wasn’t that fun? You got to keep piling on the profits in a scenario that would leave most traders with a loss.
But not you! You used the wheel strategy and protected your capital. In fact, you probably never even broke a sweat. We don’t need to worry with this strategy. We let time take care of everything.
There you have it- you now know how to use the wheel strategy!
Did you like this post? What is your favorite part of this strategy? Is there anything else that I could’ve mentioned? Make sure to let me know!