How the Wheel Option Strategy Works

  by Shelley Seagler

There are many different options strategies designed to generate an income. While covered calls are the most popular, traders may also use iron condors, butterfly spreads, diagonal spreads or calendar spreads to generate income that may be less risky or more lucrative than simply buying dividend-paying stocks or conventional bonds. The wheel option strategy is a great way to boost income without the need of complex, multi-leg option strategies.

Let’s take a look at how the Wheel Option Strategy can help you generate an attractive income, as well as some alternatives to consider.

What Is the Wheel Option Strategy?

The Wheel Strategy, also known as the Triple Income Strategy, is an options trading strategy designed to generate an income from option premiums. If you have enough cash to purchase 100 or 200 shares of a target stock, you can use the strategy to generate premium income and/or potentially acquire the stock at an attractive price.

Wheel Option Strategy

Option Wheel Strategy Diagram – Source: OptionsTradingIQ

The Wheel Option involves a few steps:

  1. Sell a cash-secured put. The goal is to collect premiums without assignment, but if the put is assigned, the idea is that you will take assignment and hold the stock.
  2. Create a straddle. If the cash-secured put is assigned, sell another cash-secured put along with a covered call to create a straddle.
  3. Sell two covered calls. If the stock goes up, the call option is assigned, and you collect three premium payments. If the stock goes down and you’re assigned 200 shares, sell two covered call options, creating five premium payments in total.
  4. Keep selling covered calls to sell the stock. As you acquire shares through put assignments, you keep selling covered calls over your entire position. Once the calls are assigned, you start over. You can use the same stock again or use a different one.

A simpler version of the Wheel Option involves fewer steps:

  1. Sell a cash-secured put with the goal of collecting premiums without assignment.
  2. Sell covered calls against the stock if it’s assigned to you until one is exercised.
  3. Repeat the process once you sell the stock through a call assignment, you start over. Again, you can repeat the process on the same or different stock.

Of course, the biggest risk with these strategies is that you will average down too far—or the capital loss on the shares exceeds the value of the premium payments received. The less obvious risk occurs when the stock rises sharply higher, which creates a significant opportunity cost since you’re obligated to sell the stock at the covered call strike price.

How to Find Suitable Stocks

The key to successfully using the Wheel Strategy is finding suitable stocks. Since you’re writing cash-secured puts and covered calls, you should be comfortable owning any stock that you use for the strategy. You should also ensure that the stock is a reasonable price because you may need to buy 100 or 200 shares (e.g., no Berkshire Hathaway Class A shares).

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Some common attributes of high-quality stocks include:

  • Rising revenue.
  • Positive net income.
  • Positive free cash flow.
  • Bullish analyst ratings.
  • Reasonable volatility.
  • Dividend.

At Snider Advisors, we look at a combination of fundamental metrics, such as bankruptcy risk, and technical metrics, such as volatility over a multi-year period. The Snider Investment Method and the Lattco automated trading platform include built-in tools to assist in selecting the right stocks when executing option trades designed to generate income. Along with rigorous stock screening criteria, the Snider Method uses the same option trades as the wheel strategy, but includes more defined rules and risk management features.

Wheel Option Strategy

Lattco’s Dashboard – Source: Snider Advisors

It’s equally important to select attractive options:

  • Put and call options should have a ~70% probability of being out-of-the-money in order to minimize the odds of assignment. You may want to settle for a lower premium further out in order to avoid the risk of early assignment.
  • Call options should be higher than the net stock cost whenever possible, although you may need a lower strike price to get an attractive premium. Either way, the strike price and premium that you choose will determine the strategy’s profitability.
  • Roll for a credit when possible and take assignment when rolling is no longer profitable.

If you want to learn more about stock selection, take our free Stock Selection 101 ecourse to discover simple strategies to help you rationally evaluate stocks.

Alternatives to Consider

The Option Wheel Strategy relies heavily on cash-secured puts to generate an income and covered calls to recoup any losses if the stock is assigned. Depending on your goals, you may want to consider alternative strategies to enhance upside potential, reduce risk or target specific outcomes in all kinds of different market conditions.

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Some other income-generating option strategies include:

  • Covered calls involve writing a call option against a long stock position in order to generate extra income. The strategy is most profitable if the stock moves near the strike price without actually surpassing it.
  • Credit spreads involve buying and selling equal numbers of options with different strike prices or expiration dates. Depending on the options selected, spreads can be moderately bullish/bearish or neutral, providing traders with a lot of flexibility.
  • Cash-secured puts involve selling a put option and setting aside enough cash to buy the stock if it’s assigned. Rather than writing out-of-the-money CSPs, like the Wheel Option Strategy, investors can use them as a means to strategically acquire stock.

When using any option strategy, it’s important to understand the pros and cons, as well as the unique risks associated with the strategy. It also helps to review ways to mitigate losses by rolling up or down to a different strike price or rolling out options to a later expiration date.

The Bottom Line

The Wheel Option Strategy, or Triple Income Strategy, is designed to maximize premium income through the use of cash secured puts, straddles and covered calls. By keeping the stock and option selection tips in mind, you can maximize your chances of success and start generating more income than conventional dividend stocks or fixed income investments.

If you’re looking to generate income from options, the Snider Investment Method is a strict set of rules utilizing both covered calls and cash secured puts to create income from your portfolio. Our goal is to ensure cash flow in retirement using a combination of stock, options, and cash, along with specific techniques applied in a specific sequence to maximize your portfolio’s potential income.

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