The Wheel Strategy is a popular approach for traders seeking consistent income. Sometimes referred to as “the Wheel,” the Wheel Strategy is a delicate balance of income generation and risk management using cash-secured puts and covered calls to make money on options premiums and pick up new stocks at discounts if they go to assignments. No worries—we’ll cover how the Wheel Strategy works in great detail and clear up many of these terms we’re throwing at you!
What can you expect from our guide covering the wheel strategy and its role in options trading? This guide will give you an excellent overview of the Wheel Strategy and how it works, along with its benefits for options traders. We’ve included a step-by-step process for setting one up in your subsequent online trading sessions, as well as some tips to navigate this technique and the potential risks that traders might run into along the way.
What Is the Wheel Strategy?
A cyclical process, the Wheel Strategy, is defined by traders selling puts until assigned the stock and then holding the stock while selling calls until the stock is called away. As we discuss how this strategy works below, you’ll quickly find that it can be repeated indefinitely, which is why this cyclical process is known as the “Wheel.”
Definition: The Wheel Strategy is an options trading strategy that helps inventors generate income and reduces the cost basis of stocks. Traders gain income through the premiums collected from selling cash-secured puts and covered calls. It can be used on stocks and index ETFs investors feel bullish about.
Simple Breakdown
The Wheel Strategy involves selling cash-secured puts and selling covered calls. Gaining ownership of the stock through selling a cash-secured put ensures that selling a covered call can happen, and the trader continually repeats these steps to reduce the cost basis of the stocks.
Cash-Secured Puts
Investors must first sell a put option for the stock they want to use. This sets a lower buy price compared to the current market price. Two scenarios can unfold from here. The option can expire as worthless if the stock price stays above the put’s strike price, resulting in the trader or investor keeping their premium. The other scenario is the stock price dropping below the strike price and the trader being required to buy the stock.
Covered Calls
Following the sale of a cash-secured put, the trader now owns the stock if the stock price drops below the strike price. The next step in the Wheel Strategy is to sell a covered call option where the trader sets a higher “sell” price than the current market price. The option expires as worthless, and you will get to keep the premium if the stock prices remain beneath the call’s strike price.
What Is the Goal?
The end goal of combining the two techniques of selling cash-secured puts and covered calls is to enjoy a steady income from selling covered calls on stocks you already own. Traders can benefit from steady premiums on these sales (if they expire as worthless), or they can sell the shares to another trader and start the process again, selling more cash-secured puts to continue the “Wheel.”
How the Wheel Strategy Works: A Step-by-Step Guide
Look at how the Wheel Strategy works firsthand for traders and investors who want to maintain steady income through premiums. We’ll outline what you must do to execute this relatively simple trading strategy and what some of the potential outcomes can be based on how the stocks, options, or ETFs shift with market movements.
Step 1—Sell Cash-Secured Puts
Cash-secured puts are where online traders sell a put option on an asset while also putting cash aside in the event that the asset is assigned. Traders use this cash to purchase the asset if the stock price falls below the strike price (they’re required to do so, as per the conditions of trading cash-secured puts). It’s considered a conservative strategy, but there’s limited risk involved and a few ways to profit from the technique, no matter the initial outcome.
The mechanism behind selling puts is that traders collect premiums while potentially buying the stock at a lower price. Selling put options helps traders receive a premium upfront, and they can keep it as profit so long as the stock price stays above the strike price. In the event that the stock price falls below the strike price, traders must buy the stock, but they can get it for a much lower cost than the market price!
Let’s look at an example to get a good idea of this trading technique in action. An investor decides to sell a put option on XYZ stock. It’s currently trading at $100, and the investor sells a cash-secured put contract with 100 shares at a strike price of $80. The put needs $8,000 in cash to be maintained (100 shares x $80).
Step 2—Buying the Stock if Assigned
If the stock price drops below the strike price of $80, the trader must buy the stock. They now own the stock and could get it for $80 instead of the current market price of $100, thus getting a deal! Part of selling cash-secured puts is setting aside money to buy the stock in the event it’s assigned, so traders should have no problem picking it up. The alternative scenario was the options expiring as worthless at expiration, with the stock price staying above the strike price. The trader gets to keep the premium.
Step 3—Sell Covered Calls
Covered calls are a trading strategy in which investors own the underlying stock and simultaneously sell call options on that same stock. Traders own these stocks or options due to assignment from the stock price dropping below the strike price upon the expiration date. Selling covered calls can help investors and traders generate additional income once the stock is owned.
In our example, the trader who bought a $100 stock for $80 when it went to assignment might want to set a sell price of $90 or $100 (no more than the market price of $100). Because the trader expects the stock price to remain steady, the options typically expire as worthless, and you get to keep the premium (this happens when the stock prices remain beneath the call’s strike price).
Step 4—Repeat the Process
This unique trading cycle (“wheeling”) lets traders continue repeating the process by selling cash-secured put options on the same stock, regardless of the put option expiring out of the money or in the money. Traders can continue generating income between selling puts and potentially acquiring new shares.
The Wheel Strategy is great for a steady income stream. Investors can earn passive income by selling options and collecting premiums, and it can be done without active management. The premiums that investors and traders get from selling these options help lower the underlying asset’s overall purchase prices.
Benefits of the Wheel Strategy
Using the Wheel Strategy offers a host of great benefits for traders who are looking for a conservative, low-risk approach to additional income generation and acquiring new stocks at a discounted price. We’ve outlined the primary benefits of using the Wheel Strategy below to give you an idea of how it could benefit your goals and objectives in online trading.
Consistent Income Generation
Using the Wheel Strategy guarantees a regular collection of option premiums. Through selling cash-secured puts, investors can own new stocks and get them for a lower price than the market value. If the stock price stays above the strike price, traders can keep the premium they received upfront when writing the call. Even when selling covered calls, traders can either keep the premium if stock prices remain beneath the call’s strike price or make a profit by selling the covered calls at a significant markup compared to what they paid.
Potential to Buy Stocks at a Discount
One of the main advantages of using the Wheel Strategy in online trading is the opportunity to acquire stocks at a lower price than market value. In selling cash-secured puts, if the stock prices drop below the strike price, traders’ options or stocks go to assignment, meaning that the trade must purchase the stock, and they officially have ownership of the underlying asset. Although they didn’t get the stock’s premium, they could buy it at a discounted price. They can then turn around and sell covered calls to make a profit or collect premiums on those trades.
Lower Risk Compared to Traditional Options Trading
By managing risk using cash-secured puts and covered calls, the Wheel Strategy is a low-risk technique that allows traders to benefit regardless of whether the put option expires from the money or in the money. With cash–secured puts, traders can collect premiums or get new stocks at a discount, no matter which side of the strike price the market value falls upon the expiration date. Covered calls are similar; the two outcomes are the investors collecting the premiums or selling the shares for a significant profit due to the discount they got through the cash-secured put sale.
Flexibility
The nice thing about the Wheel Strategy is that it can be adapted to various market conditions and stock choices. For instance, if the share price falls unexpectedly during the option’s life, the trader or investor can decide to keep or sell the share, minimizing potential losses in either scenario.
Key Considerations Before Using the Wheel Strategy
The Wheel Strategy might sound like a guaranteed way to make steady money through selling cash-secured puts and covered calls, but there are some additional things you should know and consider before using this technique in your next trading session.
Choosing the Right Stocks
Part of correctly using the Wheel Strategy is choosing the right stocks to sell cash-secured puts and covered calls. Some stocks are better than others for this Strategy, so we’ve outlined the primary criteria for choosing the right stocks and options for this trading technique.
- High Liquidity—The best stocks for the Wheel Strategy should be ones that can be bought or sold easily and quickly without significantly affecting their price.
- Stable—These stocks have low volatility, meaning the price moves more slowly or stays relatively stable. You don’t want to use the Wheel Strategy with stocks whose prices fluctuate rapidly.
- Dividend-Paying—These stocks are shares of companies that regularly distribute to investors a portion of that company’s earnings. The portion of the profits that is distributed is called a dividend. Dividends can be paid out in cash or shares. Look for dividend-paying stocks if you want to use the Wheel Strategy.
- Fundamentally Strong Stocks—When a company is fundamentally strong, it has a low debt dependency. These companies need only low debt to do their business, and their stocks are the best to use if you want to execute the Wheel Strategy.
Avoiding volatile stocks is critical because the Wheel Strategy performs best in moderate-volatility markets. High volatility stocks lead to increased premiums, but there’s the higher risk of greater price movements. This can lead to assignments when selling cash-secured puts at more unfavorable prices.
Strike Price Selection
Choosing the right strike price is essential to balancing income potential and risk. Risk-tolerant traders might consider a higher strike price on covered calls or cash-secured puts, while conservative investors with a lower appetite for risk might opt for a lower strike price.
Follow these tips for selecting strike prices that align with your investment goals:
- Put Options: Choose strike prices that you are comfortable buying the stock but should be at or below the current market price.
- Call Options: Choose strike prices that you are comfortable with selling the stock at, but it should be at or below the current market price.
- For put options, choose a strike price where you have enough cash in your account to pay for the stock if it gets assigned, and you must purchase it.
- To make the Wheel Strategy work, you must get assigned when selling a cash-secured put. Choose a strike price close to the current price to increase the likelihood of the stock getting assigned.
- Consider strike prices with likely resistance on the chart for covered calls.
- Another consideration when setting the strike price for a covered call is to choose strike prices with a narrow bid/ask spread.
Timing and Expiration Dates
There are a few factors to consider when choosing the correct expiration date on cash-secured puts and covered calls, especially if you’re attempting to use the Wheel Strategy.
If you’re more of a short-term investor, weekly options could be a good choice for you, while long-term investors might find monthly or quarterly options much more appealing. In terms of a contract’s length, the general rule of thumb is that longer contracts have more extrinsic value, meaning that investors collect more money in the long run. Conversely, contracts with shorter expirations are far more sensitive to volatility because there’s not enough time for investors to realize a profit.
Potential Risks of the Wheel Strategy
Let’s discuss the risks associated with using the Wheel Strategy. Many investors and traders prefer this limited-risk, conservative trading strategy. Still, this technique has some potential dangers that anyone should know before implementing it into their trading strategy.
Stock Price Falling Significantly
When selling cash-secured puts, the stock price changes significantly, leading to the put being exercised and the trader being assigned the shares at a discount price (the strike price). While the investors get a deal on the stock and now have ownership, there’s the downside risk of the stock not rebounding as expected. You could be stuck with a losing position on your portfolio, or you could make a limited profit to rid yourself of the stock.
Risk management techniques like using stop-losses or protective puts can be helpful when dealing with the potential risks of the Wheel Strategy. Investors can purchase a put option on their stock to limit potential risk. They can also use stop-loss orders to automatically sell off positions when they drop to a certain level so as not to incur any further losses.
Stock Price Rising Beyond Call Strike Price
If a trader buys a call option on a stock and the stock price goes up significantly over the strike price, that trader is limited in their potential profit. This is because the trader can only purchase the stock at the strike price even if the market price is higher, and this caps the profit between the strike price and what you paid for the option. Basically, traders run the risk of losing out on further gains if the stock price exceeds the call strike price.
One of the significant risks of the Wheel Strategy is missed opportunities where traders may potentially experience the regret of selling at a lower profit than possible. Even though the stock could rise further, the most money you can make on the trade is the difference between the strike price and the price you paid to get the option following the assignment.
Market Volatility
Sudden market changes can impact the performance of the Wheel Strategy, which means that stable, moderate market movements are the best conditions for executing this trading strategy. In a high-volatility environment, there’s the risk of significant price movements, which can trigger assignments at favorable prices. The market could move in such a way that the price at which the stock is assigned to the seller offers limited profit potential, as the top profit is the difference between the strike price and the price the seller paid after the option is assigned.
Tips for Executing the Wheel Strategy Successfully
Follow these tips and tricks to successfully implement the Wheel Strategy. If you’re a new trader, remember to start small with this technique, monitor the market closely to determine appropriate strike prices, diversify your portfolio’s positions, and practice good risk management techniques to minimize losses and maximize profits.
Start Small and Build Confidence
If you’re starting with the Wheel Strategy, it’s best to start small and build from there once you get experience and grow confidence in how the strategy works. To start, choose low-volatility stocks that can be bought and sold quickly. These stocks should be dividend-paying and linked to a fundamentally strong company.
Once you’ve learned the cyclical nature of this strategy and the overall basics of where to set your strike prices and expiration dates on cash-secured puts and covered calls, you can then begin working in risk management tools like protective puts or stop-loss orders.
Monitor the Market Regularly
It’s key to monitor the market closely for major movements that might affect the underlying stocks. When selling cash-secured puts, investors have the choice of allowing assignment or rolling the option forward, so they must monitor the market as the stock price approaches the strike price. When selling covered calls, traders have to decide if they want the stock called away or buy back the option to retain ownership of the stock.
Traders and investors need to be vigilant and closely monitor stock market movements so they can make the appropriate decisions following the sale of cash-secured puts and covered calls.
Diversify Your Positions
A diversified portfolio is a healthy portfolio. Traders should spread their capital out over multiple investments in multiple sectors to hedge against potential risks that come with the natural movements and swings in the options market. Avoid putting all your capital into one or only a few stocks. If the investment sours, you have a ton of money riding on those few positions, and now you’re in jeopardy of losing them. Spreading your cash to mitigate potential losses and experience slow, steady growth is best.
Risk Management Practices
As we mentioned earlier, it might become appropriate to incorporate risk management tools into these trades, such as stop-losses, protective puts, or simply adjusting strike prices, as you gain more experience with the Wheel Strategy.
– Stop Losses: These orders trigger an automatic sale on any option or stock whose price falls to a level that you’re not willing to go past in terms of capital loss. These orders allow traders to exit certain positions sooner rather than later, minimizing losses.
– Protective Puts: Using a protective put option gives the trader the right to sell the stock but also offers protection if the stock declines below the strike price. These can be worked into the Wheel Strategy, ensuring protection against losses and making room for capital appreciation if the stock value goes up.
– Adjusting Strike Prices: Sometimes, the best way to manage potential risks is to change the strike prices on the cash–secured puts and covered calls you’re dealing with. If the stock value outlook isn’t so good and you’re feeling bearish, it’s best to use a lower strike price to reduce risk and generate more premiums.
Comparison—The Wheel Strategy vs. Other Options Trading Strategies
How does the Wheel Strategy in options trading differ from other strategies and techniques used by investors online? We’ll lightly touch on how the Wheel stacks up against other trading strategies that investors use when managing their portfolios and dealing with potential risks.
Income Focused Strategies
The Wheel Strategy uses covered calls and cash-secured puts in conjunction with one another, which is different from using those two techniques alone. This trading technique not only allows traders to collect premiums on selling short puts and covered calls, but there are opportunities with put sales to acquire new stocks at a lower strike price than the current market price. Traders can sell covered calls and earn premiums or allow the stock to be led away, ensuring a profit.
Trading using only covered calls or only cash-secured puts really limits the investor’s potential benefit from the trade. This makes the Wheel Strategy desirable because it offers multiple paths to reaping some kind of reward.
Risk Levels
Compared to other approaches, the Wheel Strategy’s risk management is much more conservative, and the overall risk is much lower than that of different trading strategies. You can generate considerable income through premiums, but there are also opportunities to gain and unload stocks methodically through selling cash-secured puts. While some learning and experience go into the Wheel Strategy, it’s one of the better techniques for new traders who want to use a strategy with little risk or downside.
For more information on trading techniques, check out our strategies page!
Enjoy This Low-Risk Trading Strategy
If you’re looking for a steady trading strategy to generate consistent income with little risk, it’s worth checking out the Wheel Strategy, where you’re in a continuous cycle of selling cash-secured puts and covered calls. While there are many benefits for investors, there are some risks you run using this trading technique:
Benefits
- Consistent Income Generation
- Potential to Get Stocks at a Discounted Price
- Low-Risk Trading Strategy
- Flexibility for Investors Based on Multiple Positive Outcomes
Risks
- The Stock Price Falls Significantly
- The Stock Price Can Rise Beyond the Call Strike Price
- Market Volatility Can Trigger Assignments at Unfavorable Prices
If you’re new to the Wheel Strategy, the best approach is to start with small trades and implement sound risk management strategies to retain as much of your capital as possible.
