Wheel Strategy: Generate Income Using Options

The wheel is a great options strategy for generating semi-passive income with a lower risk than many other strategies. What really shines in the options wheel is the consistency and scalability which can both benefit small and large accounts. When trading options, always remember that the market will always be a game of chance. No matter how much time you put into research, the market will always remain unpredictable, and therefore it is important to only start with what you are willing to lose. Make a wise financial decision, and do not put all of your investing money into the wheel.

That being said, the amount of money required to start the wheel strategy is at least $2500. Having $2500 in your account ensures that you will be able to trade contracts on stocks or etfs which are above $20, which have significantly better risk-to-reward compared to penny stocks.

Step 1: Pick a Stock

The stock you pick for your wheel is extremely correlated to the performance of your account.

Only pick a stock that your are bullish on, or think will rise in the long term.
Only pick a stock that you can afford. Your account value must be 100x greater than the price of the stock.

Step 2: Sell a Cash Covered Put

Getting into the wording for all strategies can get confusing, so lets break it down into digestible chunks. We shall first explain selling cash secured puts.

Cash Secured = We have the money to buy the shares if assigned
Selling a Put = We write a contract that someone else buys. When they buy the contract, we agree to buy 100 shares of a stock that we choose, in the case that the stock falls under a strike price that we determine. In return, the buyer of the contract pays us a “premium”, which is just money in return for the contract.
Contract = A contract that is either bought or sold, each contract references to 100 shares.

Example — PINS FEB 05 ’21 67 Put (6.18)

In this put we agree to buy 100 shares of PINS if PINS drops down below $67. At the time of this example the price of PINS is now is $68.40, our contract will need $6700 of collateral, because the contract references 100 shares. The person who buys our put has until 5/2/21 for their contract, and after that, if it has not dropped below $67, then it will expire worthless and we can go into another put.

Generate Income:

The person who bought our put paid us a premium, which in the above example is $6.18. In reality, that is $618 because our contract is for 100 shares. If the contract expires worthless, then we can keep the $618 as pure profit, and this is where we make our money. Theoretically, we can make this money forever, by repeating these steps of selling a contract, expiring worthless, keeping premium, and selling another one.

However, if we want to make the most money, we have to find a good balance between premium and strike price It is up to your risk tolerance to choose when you want to increase your premium or lower your strike price. Generally:

A lower strike price will result in lower risk, but lower premium.
A higher strike price will result in higher risk, but higher premium.

It is up to you to find that boundary, but generally, if you want an option to be worth your time, your premium should be at least 1% of the stocks price.Taking premiums lower is considered a waste of time, and will not generate significant profits. Finding your tolerance is important. In our in-depth guide: Selling Cash Secured Put Options: Get Paid To Buy Stocks At A Discount you will also learn the four possible outcomes.

Step 3: Repeat until assigned

Did the put that you sold expire worthless? Great job, you just netted all the premium from that contract as profits. But what next? Although not as of an exciting answer, just sell another put, maybe upping your strike price, or lowering depending on how you felt about the last one. Continue to do this until the contract that you sold expires in the money, or the price of the stock finally reaches below your strike price, and the person assigns.

Step 4: Sell a Covered Call

The put that you sold just expired ITM (in the money)! The person who bought your contract has decided to assign, and you are forced to buy 100 shares of that stock (assignment).

You now have 100 shares of a stock, what to do next?

Start earning a premium on your 100 shares by selling covered calls. Lets first break down selling covered calls:

Covered = You have 100 shares of the company.
Selling a Call = We write a contract that someone else buys. When they buy the contract, we agree to sell 100 shares of a stock that we own, in the case that the stock goes above a strike price that we determine. In return, the buyer of the contract pays us a “premium”, which is just money in return for the contract.
Contract = A contract that is either bought or sold, each contract references to 100 shares.

Example — WKHS JAN 15 ’21 24 Call (1.63)

With this call we agree to sell 100 shares of WKHS, by or before 15/1/21, in the case that WKHS price rises above $21 and the buyer of the call decided to exercise the contract. In return for this opportunity, we get paid $1.63 per share of WKHS, which is actually $163, because the contract references 100 shares.

In our in-depth guide: Selling Covered Calls: An Income-Generating Options Strategy you will also learn the risks and rewards of the covered call options strategy.

Step 5: “Turn the Wheel!”

Now it is easy to see the power that the wheel strategy has. You can keep pocketing this premium every time one of your contracts expire worthless, and build this up into a large account! Congratulations, you just spun the options wheel strategy. Time to reset to Step 1, or just sell another put on the same stock if your outlook has not changed.

Things to Consider with ‘The Wheel’ Strategy:

Sell the first put when implied volatility is in the higher end of the 6-month range
Wait for a 5% pullback before selling the first put
Place a stop loss 10-15% below where the stock was trading when the put was first sold
Adjust your stop loss lower when multiple puts have expired worthless
Will you sell the first put slightly out-of-the-money or at-the-money?
Will you sell the calls slightly out-of-the-money or at-the-money?
Sell the first put when RSI is below 30
Stick to low beta, high dividend stocks. Think of stocks you would be happy to own in your retirement account
You can also use this strategy on ETF’s to reduce the bankruptcy risk
If the stock continues to fall, it’s ok to sell a call below cost only if you have received enough put premiums to offset the cost basis
If you have sold numerous puts, your actual cost basis can be very low

Conclusion

The Wheel Trade is a great way to generate income throughout the year consistently. The constant income sources from put sales, dividends, stock appreciation and covered call sales generate returns that can exceed a simple buy and hold strategy. When choosing your short puts, it is as simple as going one strike out-of-the-money. Once you are assigned start selling calls 2-3% out-of-the-money until you can get rid of the shares profitably. The most important part of the Wheel Trade is to keep track of all your income from each trade. Without that information you won’t be able to tell if you are truly profitable or not.