In this article, we are going to explain the Basic Stock Option Wheel Strategy. We will break it down and explain what it is and when is a good time to utilize the strategy.
We will also walk through the steps with a real-world example showing exactly how to execute this strategy on the TastyWorks Option Trading platform. Please look in the notes below and use the link for the discount when you open an account.
https://start.tastyworks.com/#/login?referralCode=MB9KEHV4RK
As always I want to state the disclaimer that I’m not a financial planner and am not offering trade advice. I’m also not your mother, so please do your own research and decide for yourself how to invest your money. Do not invest any more money than you are willing to lose.
What is the Option Wheel Strategy and when do we use it?
The option wheel strategy is a bullish strategy and used when we think a stock will go up in price. If at any time our directional assumption changes and we are no longer bullish then we will want to close out our positions.
However, there is one simple caveat. Since we believe that its difficult if not impossible to time the market, we are never completely out of the market sitting in all cash or anything like that. So this strategy can be used in some form for some percentage of your portfolio at all times. It also can be used in any stock, fund or ETF that has options. So there is always a place for it. If you are new to options, it is a great way to learn and get introduced to the world of options.
Jumping right into it:
The wheel strategy can be summarized as follows:
Step 1: We sell an out-of-the-money cash-secured put.
Step 2: If the put option ends up expiring in-the-money, we are assigned the stock.
Step 3: Sell out-of-the-money call option against that stock position.
Step 4: If the option moves to in-the-money then our stock is called away closing the position. If the stock option expires out-of-the-money as worthless we can sell another out-of-the-money call option in the following month. We can repeat this process until the stock is called away.
Let’s walk through the steps to demonstrate the stock option wheel strategy with a real life example.
Step 1: Pick a stock we are bullish in and sell an out-of-the-money Put option.
We are going to use the TastyWorks Platform which is a great Brokerage Platform for trading options. Please use the link below and see the promotion for opening a new account.
https://start.tastyworks.com/#/login?referralCode=MB9KEHV4RK
We are going to use INTC Intel Corporation for this example. We are picking Intel because we are long term bullish and believe the stock will increase in value. The stock price is 54.01 so it is still not too high. We need to make sure and pick a stock or ETF that we can afford. Our account value must be 100x greater than the price of the stock since 1 option contract is equal to 100 shares of stock. In other words, the $45.04 stock price x 100 shares = $4,504 that we must have in our account in case we are assigned.
When we Sell a Put, we are writing a contract that someone else buys. When they buy the contract, we agree to buy 100 shares of the stock at the strike price. In return, the buyer of the contract pays us a “premium”, which is just money in return for the contract.
Again, each: Contract = 100 shares of stock
So we go to the trade page on the Tastytrade Platform and look for the expiration between 30-55 DTE or Days to Expiration. This is the ideal time frame and sweet spot for this strategy. We are going to pick the $42.5 strike price which is the 31 delta price. This means that the stock has a 69% (1-delta) chance of expiring out-of-the-money or worthless. This is what we want since we want the price to increase.
Now here is where the magic really happens!
The amount of money that we collect in this example you can see is $1.25 which is the mid price. Remember this is really $125 since each contract is 100 shares. Now when we hit review and send, that money is deposited or credited to our account immediately.
This is the secret and where we make our money and reduce our cost basis by $125 versus just buying and being long 100 shares of the stock.
Theoretically, we can continue to make this money month after month as long as the stock keeps going higher. Once the contract expires worthless at expiration, we just sell another put contract in the next month.
Now eventually the stock is not going to continue to go straight up. When the stock does settle and come down below the strike price we will be assigned. Once assigned, we will own 100 shares of stock.
Step 2 – We are assigned and own 100 shares of stock.
Now, once we are assigned we own 100 shares of the stock. In other words, we are long 100 shares of stock.
So we move on to the next step of the wheel strategy.
Step 3 – We sell an out-of-the-money Call option
When we Sell a Call, we are writing a contract that someone else buys. When they buy the contract, we are agreeing to sell 100 shares of that stock at that strike price. This will happen when the stock moves above that strike price on or before expiration. In return, the buyer of the contract pays us a “premium”, which is just money in return for the contract.
Again, each: Contract = 100 shares of stock
So we go to the trade page on the Tastytrade Platform and find the expiration between 30-55 DTE or Days to Expiration. Again, we believe this is the sweet spot for this strategy since we can collect a good premium and it is still not too far away. In this example, we are going to pick the $47.5 strike price which is the 25 delta price. This means that the stock has a 75% chance of expiring out-of-the-money or worthless.
The amount of money that we collect in this example you can see is $1.21 which is the mid price. Remember this is really $121 since each contract is 100 shares. That money is deposited or credited to our account immediately as soon as we hit review and send.
We have now collected additional premium and further reduced our cost basis by another $121 versus just buying and being long 100 shares of the stock. Now we are long the stock and short a Call option. This is called a Covered Call and is still a bullish strategy. So we do still want the stock to continue to go up.
As long as the stock stays below the strike price we still own the 100 shares of stock. Once the contract expires worthless at expiration, we just sell another Call option in the following month. We can continue to reduce our cost basis month after month by selling a Call option and collect the additional premium until the stock is called away.
Step 4 – The stock price moves above the strike price and is in-the-money at or before expiration.
Our stock is called away and the position is closed.
When the stock moves up above the strike price, we are obligated to sell the 100 shares of stock at that strike price.
Since we already own the 100 shares they will just be called away resulting in our position being closed.
We can now start this process all over again by selling a cash secured Put option if we are still bullish in the position. Or we can pick a different stock or ETF and use the same strategy again.
How can we lose?
Seems like a “no brainer” right?
However, there is no “free money”. There is always risk with any strategy and we can lose using this strategy as well.
This is a bullish strategy so we are hoping that the stock increases in price or at least stays where it is. We will be assigned and own 100 shares of the stock if the stock moves down in price below the strike price.
The max loss occurs if the stock goes to zero.
Why use the Option Wheel Strategy?
It is better than owning the stock outright (since it reduces risk and increases profits).
If we are going to be long a stock anyway, why don’t we reduce our cost basis by collecting some option premium. Every time that we sell a Put or a Call in the Wheel Strategy, we collect additional premium which reduces our cost basis.
The maximum risk that we have on at any one time is the value of the stock. It is the same risk as if we own the 100 shares of the stock outright. Any stock can go to zero if the company goes out of business. However, are we going to be using this strategy with stocks that we think may go out of business? Not likely. We are going to pick stocks that we think are going to go up over time. We can also use this strategy with an ETF or fund that tracks the S&P 500 as well.
You also don’t have to be concerned with the stock upside price either. Since when we sell the call option, we already own the 100 shares of stock. The Call is covered if the price of the stock moves up past the strike price since our shares will just be called away. This is actually what we want to happen. We are never at risk of losing any more than we would by owning the stock outright.
In any given year, there will typically always be stocks and sectors that do well.
It is always hard to try and time the stock market. We believe that we should always have some bullish positions in any market. We believe that underperforming sectors will normally come back at some point. That is why there is an entire sector for those stocks.
Alright, that is the option Wheel strategy. It’s a great way to reduce our cost basis and maximize profits when we are bullish in a stock or ETF. Please let me know what you think of the wheel strategy and if you are using it in the comments section down below.
If you got something out of this video, please click the like button and make sure you subscribe so you are notified of the next one.
Thanks so much for reading!
Are you using the stock option wheel strategy? Please let me know when and how you are using it in the comments below.