The Options Wheel Strategy Explained

In this article, we will discuss

The options market is a risky segment that can lead to substantial profits or losses. Since it involves a great deal of leverage, both gains and risks are multiplied. For this reason, many moderate or conservative traders steer clear of this market segment — and miss out on many potentially gainful trading opportunities.

However, what if we told you that there was one trading strategy that could help you take calculated risks — so you could potentially profit in some manner no matter how the market moves? While you may be skeptical at first, you may view things differently once you become familiar with the options wheel strategy.

True to its name, this strategy involves a few simple steps, repeated over and over again in a cyclical manner. Let us take a deep dive into what this technique involves and how you can implement it.

What is the Options Wheel Strategy?

The options wheel strategy is a trading technique that aims to generate steady income for traders using a combination of option sales. To implement this strategy, you need to be slightly or moderately bullish on the underlying asset. You then start selling cash-secured put options on this asset and profit from the premiums until the puts are assigned.

You then start selling covered call options on the asset that you own (due to the put becoming assigned). This again leaves you with the premiums as profits until the calls are assigned. Once that happens, you begin the wheel trade all over again.

A Closer Look at the Key Elements of this Strategy

At first glance, the options wheel strategy may seem too simple. While it’s no doubt easy to implement, it helps if you understand the nuances of this trading method, so you can effectively use it to your advantage. Let us break down the key aspects of this strategy, which are cash-secured puts and covered calls.

  • Cash-Secured Put

A put option is a contract that gives the buyer (or options holder) the right to sell an asset at the exercise or strike price. When you sell a put option, the options buyer can either exercise the option on the expiry date or let it expire worthless. Typically, if the asset’s price increases past the exercise price on expiry, the put option becomes worthless.

However, if the asset’s market price is lower, the options buyer will exercise their right to sell the asset at the higher strike price. You need to have enough cash in your trading account to cover the cost of this purchase. This is what makes a cash-secured put.

For instance, say you sell a put option with a lot size of 100 shares and a strike price of Rs. 200. To make this a cash-secured put, you need to have Rs. 20,000 in your account. In addition to this, you will also have to ensure that you have the margin money required to execute the trade.

  • Covered Call

The other important aspect of an options wheel strategy is a covered call. Here, you sell call options for an asset that you already own. If the cash-secured puts in this strategy have been assigned, you will own the underlying asset that you purchased from the options buyer. You can then write call options on this asset and profit from the premiums.

If the asset price rises above the exercise price, you can sell the shares that you own, bring your asset holdings to zero and initiate the wheel trading technique from ground zero again. Hence, the strategy is likened to a wheel that keeps moving forward in the same cyclical motion.

Decoding the Steps in the Wheel Strategy

Now that you know the key aspects of the options wheel strategy, let us take a closer look at the step-by-step process to implement this technique.

  • Step 1: Choose the Underlying Stock or Security

The options wheel technique cannot be implemented on any asset in the market. You need to select the underlying security carefully. Since the first part of the trade involves selling put options, it essentially means that you are betting against the downward movement of an asset. So, you need to choose stocks or securities that are moderately bullish.

In addition to the market outlook, you should also ensure that the underlying asset as well as its derivatives have sufficient liquidity. This will make it easier for you to trade quickly and leverage any potential price movements. Choosing assets with liquidity issues can bring your wheel trading technique to a stop even before it begins.

Furthermore, you should also be prepared to own the stocks or assets you choose — in case you are assigned based on the put options sold. So, it is best to choose assets that could add some value to your portfolio overall.

  • Step 2: Sell/Write Cash-Secured Put Options

Once you choose an appropriate asset based on the above factors, you need to execute the first part of the options wheel trade — which is writing cash-secured put options. As a rule of thumb, it is advisable to choose OTM put options, where the current market price of the asset is higher than the strike or exercise price.

Let us discuss an example to make this clearer. Say you are bullish on a company’s stocks, which are currently trading at Rs. 300 per share, and you decide to implement the wheel strategy using its options. So, you write a cash-secured put option with a lot size of 100 shares and an exercise price of Rs. 290. This means you need to have Rs. 29,000 in your account to secure the put option in case you are assigned (in addition to the margin requirements).

Now, let us see what happens at expiry, which may be one of the two following scenarios:

- Scenario 1: The Stock Price Remains Above Rs. 290

Suppose that the stock price at expiry is Rs. 297. In this case, the put option becomes worthless and the buyer will not exercise their right to sell. You can pocket the premiums from selling the option as your profit and then continue the cycle of selling another cash-secured put option till you are assigned.

- Scenario 2: The Stock Price Falls Below Rs. 290

Say the price of the stock at expiry is Rs. 285. The options buyer will then choose to sell the shares at Rs. 290. Since you have the cash required, you can complete this trade easily as this was a risk you were prepared for. Additionally, you can also set off some of this cost with the premium received from the options writing. That said, do note that you may need additional capital to take delivery of the shares.

  • Step 3: Sell/Write Covered Call Options

Once you are assigned assets based on the sold cash-secured puts, you can move on to the next phase of the options wheel trade, which is selling covered calls. From the above trade, you already have 100 shares of the company in your account. You can now write covered calls on this asset.

Say the current market price of the stock is Rs. 285 (as it was in scenario 2 above). You can then choose to sell a call option with a lot size of 100 shares and a strike price of Rs. 292. Now, at expiry, any one of the following two scenarios may play out.

- Scenario 1: The Stock Price Remains Below Rs. 292

Suppose the price of the stock at expiry is, say Rs. 288. The options buyer will not exercise their contract and it expires worthless. The premium you received from writing the covered call option will be the profit you earned from this trade. You can then proceed to write another covered call and continue this process till you are assigned.

- Scenario 2: The Stock Price Rises Above Rs. 292

Let’s say the stock price at expiry is Rs. 295. The call options buyer will exercise their option to buy the shares at Rs. 292 instead. Since you have 100 shares in your portfolio, you can sell these shares and complete the assigned trade. This leaves you free to begin from step 1 again.

  • Step 4: Repeat the Trading Process

Once your covered call is assigned and the cycle is completed, you can then start the options wheel trading technique all over again. Choose the underlying asset, write the cash-secured put option, continue till assignment, then sell a covered call and continue till that is assigned.

Options Wheel Strategy: Pros and Cons

Now that you know how to implement the options wheel trading technique, all you need to do is understand its advantages and limitations before you execute it. Here are the key details.

  • Advantages of Options Wheel Trading

    The primary advantages of this trading technique are that you can:

    • Generate income continuously from options writing
    • Reduce the cost of purchasing the underlying asset from the cash-secured put
    • Benefit from the time decay in options value as the expiry nears
    • Manage risks easily in all your trades

  • Disadvantages of Options Wheel Trading

    On the downside, this strategy also carries some limitations and risks like:

    • Large initial capital requirements to secure your puts
    • Limited profits
    • Potentially unlimited losses

Conclusion

The options wheel strategy is an advanced technique that takes some practice to master. You can make use of trade simulation platforms to get better at this type of cyclical trading before entering the live markets and implementing this strategy. That said, when you do carry out wheel-based trades, ensure that you are mindful of the limitations and take appropriate measures to minimise the risk as much as possible.

Disclaimer: INVESTMENT IN SECURITIES MARKET ARE SUBJECT TO MARKET RISKS, READ ALL THE RELATED DOCUMENTS CAREFULLY BEFORE INVESTING.
The asset classes and securities quoted in the film are exemplary and are not recommendatory.
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