There are many strategies for how a trader could make money trading options. One of the ones most recommended for beginner traders is the wheel. The wheel strategy is a strategy that involves selling puts until they are exercised. Then, the trader sells covered calls using the underlying stock until they are exercised, and then repeat the process as much as possible. If you are having trouble understanding some of the terms used in this article, check out our glossary.
The Wheel Strategy
How It Works
The first part of the wheel strategy is to find a stock that you think will rise in the long term and that is affordable. By affordable, I mean the trader must be able to afford 100 shares of the stock for when the put is assigned (meaning exercised by the owner). This is because puts and calls are all done in increments of 100. You will also want it to have enough value for the premiums to be worth the effort. This should be at least $20 a share. Remember to do your research on the company and its past stock performance.
Next, the traders will want to buy a cash secured put with an expiration date of about a week or two in the future. They will want to sell it with a strike price that they are willing to buy the stock at. I recommend a cash secured put because the plan is for the puts to eventually be assigned, so you might as well be certain you will be able to afford the stock. If the put expires without being exercised, keep selling them until they are.
After that, the traders will have 100 share of the underlying stock. This is the prefect amount to sell a covered call. A covered call is a call that the trader already has enough stock to sell if it is assigned. The traders should keep trying to sell the covered call like they did the put, with the exemption of the strike price. The strike price should now be calculated based on how much premium the traders want versus the risk the call will be assigned. When the call is assigned, buy another put and the cycle begins anew.
The first advantage the wheel strategy has is that it gives traders is a way to make money why they wait for a stock to become more affordable. All the traders have to do is sell puts for the amount they were willing to buy the stock for as the strike price. Each time the underlying stock fails to fall to the strike price, they get to collect another premium from selling the put.
Another advantage is how it minimizes risk. Since you are selling both puts and calls from the underlying stock depending on what part of the wheel your on, you are at least partly hedged against the stock rising or falling unexpectedly. You make money regardless of what position you are in compared to the stock.
The wheel strategy is also very scalable. A trader can attempt to use any stock that is likely to go up in the long run, from penny stocks to stocks worth hundreds of dollars each. The trader can even sell multiple puts and calls at the same time. They can even do so for multiple different stock, if they want to diversify their portfolio as well.
The wheel strategy’s first weakness is only really relevant if you sell the puts on margin instead of using cash secured puts, like mentioned above. In this case, both the risk and the potential reward are increased. Using margin will require the trader to put up collateral that may be lost depending on the performance of the stock. This is the trade off for having more leverage from the trade.
The reason anyone would risk doing this anyway is because of the other weakness of the wheel strategy. It can be difficult to find an underlying stock with high enough premiums for its puts to be worth the effort. This is not to say that the wheel is always more trouble than its worth. It can earn a good amount of consistent cash, especially with higher valued stocks, but the premiums can be very small for smaller stocks.
The wheel strategy works by having traders sell puts for a stock they wish to buy, sell covered calls with that stock until it is assigned, and then repeat the process. The strategy is advantageous because it allows traders to make semi-passive income while waiting for a stock to go down or up. It also minimizes risk and is very scalable. One should be carful because it doesn’t completely eliminate risk and it can be hard to find a good stock to use for the strategy.
I hope this helped you understand the wheel strategy. Good luck and happy trading!