The Wheel Strategy is one of the most popular Options trading strategies among traders of all experience levels.
And the reason is that it’s very simple to execute, and can be highly profitable if traded the right way.
All you need to execute the Wheel Strategy is to sell a Put Option on entry and sell a Call Option to exit.
And that’s it!
In this guide, you’ll learn everything you need to know about the Wheel Strategy to be profitable in the long run.
And before we can get into that, we first need to know exactly…
What Is The Wheel Strategy?
The Wheel Strategy is a mid to long-term Options trading strategy that combines two very simple Option strategies:
If you don’t already know what a Cash Secured Put is, it’s simply selling a Put Option with the intention of getting assigned on it.
This is the exact strategy that Warren Buffet uses to get into his stock positions!
When you sell the Cash Secured Put, you receive a premium for it.
This premium can be seen as a way to reduce the cost basis of your stock purchase if you get assigned.
When you get assigned on the Cash Secured Put, you will be Long 100 shares of the underlying stock per Put Option.
For example, if you sold a Cash Secured Put with a strike price of 50 and the stock is below $50 at expiration, you will be assigned 100 shares of the stock at $50.
So the total capital outlay for it would be $5,000.
And let’s say for example you’ve collected a total of $500 for selling the Cash Secured Puts.
That means that the effective cost of your stock would only be $4,500!
As for the Covered Call, it’s simply selling a Call Option on every 100 shares of stock.
So if you have 200 shares, then you’d sell two Covered Calls.
And similar to the Cash Secured Put, when you sell the Covered Call, you’d also get a premium for it.
If you get assigned on your Covered Call, your shares get called away and you no longer have any shares.
These two strategies are the core mechanism of the Wheel Strategy!
How The Wheel Strategy Works
So how exactly does the Wheel Strategy work and how do you initiate this strategy?
As you can see in the diagram above, the Wheel Strategy is initiated by selling the Cash Secured Put.
Once the Cash Secured Put is sold, we simply wait to see if it gets assigned.
If it doesn’t get assigned, we just keep selling the Cash Secured Put over and over again.
And each time you sell them, you keep collecting premiums until it gets assigned.
Once it gets assigned, we will now be Long 100 shares of the underlying stock.
At this point, we now sell a Covered Call.
And again, we keep selling the Covered Call until it gets assigned and have our 100 shares called away.
Once our shares are called away, we simply go back to selling the Cash Secured Put all over again.
That’s why this is called the “Wheel” strategy because you keep doing the same things over and over again.
It’s that simple!
The 3 Income Sources of The Wheel Strategy
So how do you generate an income from the Wheel Strategy?
There are 3 income sources:
- Income 1: Selling the Cash Secured Put.
- Income 2: Selling the Covered Call.
- Income 3: Capital gains from the stock.
Most people focus on just generating income from selling the Cash Secured Put and Covered Call.
So for example, if they sell a Cash Secured Put at the strike price of 100 and then subsequently get assigned, they then sell a Covered Call at the strike price of 100 as well.
This way, you only get the premiums from selling the Options, but do not make any capital gains.
And this is perfectly fine if that’s how you want to do it.
But you can gain bigger profits if you also include the capital gains from the stock.
That means instead of selling the Covered Call at the strike price of 100, you can sell it at a higher strike price.
For example, if you sell the Covered Call at the strike price of 101, your capital gains would be $1 per share when assigned.
So per Option contract, that would be an additional gain of $100 on top of the premiums you receive for selling the Options!
How To Trade The Wheel Strategy
Now that we know how profitable the Wheel Strategy can be, how do you trade it?
Well, there are two ways to trade it:
- Single entry approach.
- Multiple entries approach.
Trading The Wheel Strategy (Single Entry Approach)
Let’s say, for example, you have enough funds to get assigned on three Cash Secured Puts.
So to initiate the Wheel Strategy, you’d sell three Cash Secured Puts.
The next step would be to wait and see if you get assigned.
Once you’re assigned, the next step is to sell Covered Calls.
But the issue with the single entry approach is that most of the time when you’re assigned, the stock would already be far below your entry price.
As you can see in the chart above, the stock has dropped far below the entry price that you’re assigned at.
And to prevent locking yourself in a loss, you only want to sell Covered Calls at or above your entry price.
But if you were to sell the Covered Calls at where you’re Long the shares, there would be too little premium to collect.
So the only choice would be to wait until the stock trades a little higher before selling the Covered Calls.
Once the stock trades higher, you can then sell the Covered Calls with the strike price at or above your shares’ entry price.
Then all that’s left to do now is to wait and see if your Covered Call gets assigned or not.
If it doesn’t get assigned, then you sell the Covered Calls again to keep collecting the premiums.
Then once your Covered Calls are assigned, you reset the whole process and start selling the Cash Secured Puts again.
This is for the single entry approach.
Trading The Wheel Strategy (Multiple Entries Approach)
For the multiple entries approach, instead of placing all your Cash Secured Puts on a single level, you split them up into multiple levels.
So for this example, if you plan to sell three Cash Secured Puts, then you split them into three levels.
This way, as the stock drops, you can always sell another Cash Secured Put to keep collecting premium.
And even if you’re assigned on the first level and you’re unable to sell a Covered Call for that level, you can still sell Cash Secured Puts as the stock goes down.
This way you’re still able to generate an income as the stock goes down.
In the chart above, you can see that the Cash Secured Puts at levels one and two got assigned.
So while you may not be able to sell a Covered Call for level one, you can still sell a Covered Call for level two.
At the same time, if the Cash Secured Put at level three expires worthless, you can keep selling another one again until it gets assigned.
This way, you continuously get an income even if the stock went down.
Whereas in the single entry approach, you’d have to wait till the stock goes up before you can sell a Covered Call.
And if the stock doesn’t go up for a long time, then you’d be stuck with shares and have no way to generate an income.
So which is better?
There are pros and cons to both approaches.
The Wheel Strategy with the single entry approach would give the best return if you’re able to time your entries well.
That means once you’re assigned on your Cash Secured Put, the stock would subsequently go back up.
But if the stock continues going down, then you’d not be able to generate any income.
On the other hand, the Wheel Strategy with the multiple entries approach is more defensive.
The biggest fear that many traders have when trading the Wheel Strategy is if the stock crashes.
With the multiple entries approach, you wouldn’t be afraid of a stock crash because you’re able both the Cash Secured Put and Covered Call as the stock drops.
But if the stock only goes past level one and subsequently goes back up, then you would have made more money with the single entry approach.
Ultimately, it comes down to if you’re more risk averse, or if you prefer to make more gains at the risk of the stock crashing.
If you’re more risk averse, the multiple entries approach would be better.
If you’re more focused on gains, then the single entry approach would be better.
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