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Often dubbed the “Triple Income Strategy”, The Wheel is an active options trading strategy, designed to generate steady income with the potential to acquire discounted stock. It involves the systematic approach of selling options, utilising two well-known option strategies known as the Cash Secured Put and the Covered Call. This strategy can be particularly appealing for investors with a rudimentary knowledge of options markets who want to capitalise on market volatility while effectively managing risk on a quality share or ETF.
Understanding the basics
An exchange-traded option is a financial derivative giving the holder the right, but not the obligation, to buy or sell an underlying security (e.g., shares or ETF units) at a specified price (strike price) on or before a certain date in the future (expiration date). Option trading strategies can be tailored to hedge risk, speculate with leverage, and generate passive income to maximise yield. The value of an option contract is derived from the following variables:
Options exist in two formats:
The assignment refers to the process of exercising the option contract. Any ITM open positions that are not closed before expiration (e.g., buying or selling back the contract) will be exercised, resulting in delivery of the underlying asset. Most contracts are denominated in “lots” representing 100 units of the underlying (e.g., 1x AAPL option contract is equivalent to 100 shares of AAPL stock).
Learn to 'wheel' in six steps
Find an underlying: Choose a share or ETF that you don’t mind holding for the long term and would be happy to see included in your portfolio. Also look for an underlying with highly liquid option markets. Signs of this include i) tight bid/ask spreads, ii) high open interest (number of open outstanding option positions), iii) high volumes (number of traded contracts per most recent trading day) and iv) frequent expiration dates (allowing for frequent trading and flexibility).
Sell a Cash-Secured Put (CSP): Begin by selling an out-of-the-money (OTM) put option, secured by enough cash to purchase the underlying if you are assigned. An OTM put involves selling a contract with a strike price below the current market price, resulting in you receiving option premium as income.
Acquire Security: If the underlying price falls below the strike price, the put option will be exercised and you will purchase the stock at that strike. This allows you to acquire shares at a potentially lower price on a security you are bullish on while keeping the premium, effectively reducing the average price paid.
Sell Covered Calls (CCs): Once you own the stock, sell OTM call options – a strike price above the current market price. Like the CSP, this will generate additional income as you receive option premiums on top of any capital gain or dividend entitlements. The CC can also generate income in a falling market.
Sell Security: If the market price of the underlying moves above the strike price on your call option, you will be required to sell the underlying at the given strike. You will profit from both capital gain on the underlying whilst also keeping the premium. You are now long cash.
Repeat steps 2-5: Rinse and repeat, adjusting the strike prices and expiration dates.
Example - a new spin on bonds trading
Step 1: Pick your underlying.
At the time of writing (July 2024), Saxo predicts the United States to cut interest rates twice this year. This will cause the value of US Treasury Bonds to rise. To expose our portfolio to this anticipation, it would be appropriate to trade the iShares 20+ Year Treasury Bond ETF (NYSE: TLT), as we would like to acquire it at a cheaper price and hold.
Step 2: Sell cash-secured put ($ = USD).
Step 3: Manage CSP position and assignment.
$TLT > $92 (put strike price) | $TLT < $92 (put strike price) |
Let the option expire worthless, keeping $111. Roll the option into the subsequent month, repeating the CSP trade to hopefully earn more income. | Acquire 100 units of TLT at $92 while keeping the $111 premium. You are now long the underlying and can move to Step 4. |
Step 4: Hold underlying and sell covered calls.
Step 5: Manage CC position and assignment.
$TLT < $93.50 (call strike price) | $TLT > $93.50 (call strike price) |
Let the option expire worthless, keeping $105. Roll the option into the subsequent month, repeating the CC trade to hopefully earn more income. | Sell 100 units of TLT at $93.50 (for a $1.50 capital gain profit), while also keeping the $105 premium from the CC. You are now long cash and can move to Step 6. |
Step 6: Repeat steps 2-5. Please note the above example excludes brokerage and exchange fees.
Benefits of the Wheel Strategy:
Risks of the Wheel Strategy:
Other Wheel Strategy considerations:
The Wheel Strategy offers active investors a structured approach to generate income and acquire stocks at potentially favourable prices. By systematically selling cash-secured puts and covered calls, investors can capitalise on market opportunities while managing risk. As with any investment strategy, it is crucial to conduct thorough research, understand the underlying assets, and align the strategy with your financial goals and risk tolerance. Whether you are a seasoned trader or a novice investor, the Wheel can be a valuable addition to your options trading toolkit.