• Bocconi Students Options Club

"The Wheel"

The Strategy


a. Explanation


The basis of “The Wheel” is a set of trades that end up creating a repeating cycle, which is where the strategy gets its name from. Furthermore, the strategy generates multiple types of income. A run-through of an example will be given at the end in case you want a detailed explanation.


Step 1


To start the cycle, select an asset eg:(stock or ETF) where you expect price volatility to decrease or anticipate that it will rise or remain stable over a given amount of time. Once you have found your stock, you select a strike price you expect the stock to stay above, and sell a cash secured put (CSP) at that strike and expiration date. It’s ‘cash secured’ as you must have enough cash to buy 100 of the underlying asset at the strike price.


Important: You expect your stock to stay above your strike price. If it is under at expiration, you obligate yourself to buy 100 shares at the strike price. You may be obliged to buy the 100 shares before expiration if the purchaser of your sold puts decides to execute his contract early. For this obligation you receive a premium. You can select various expirations. Short term expirations pay less premium, but your capital is held up for less time, whereas long term expirations pay more premium, yet you face more risks.


Step 2


In step 2, one of three things may happen.

  • If the stock is below the strike at expiration and you get assigned, you are obliged to purchase 100 shares and move to step 3.

  • If the stock is above the strike after expiration, you keep the premium as profit and repeat the cycle from step 1.

  • If the underlying stock price increases greatly or loses a lot of implied volatility before your put expires, your CSP’s current value will decrease (representing an unrealized profit as you are short in the position) e.g. at 50% profit. You can therefore close the position early before the expiration by buying the put you sold for less money. You therefore realize a profit from the premium although not the full premium. If you choose this, repeat from step 1.


Step 3

At this point you have been assigned and forced to buy 100 shares of the underlying asset at the strike price of the put you sold. The premium you received from selling the put was used to offset some of the cost of buying the shares. Therefore, you can calculate your cost basis per share by subtracting the premium received from the total you spent on the shares, and dividing that by the number of shares you bought (Your cost basis should be lower than the strike of the put you sold).

The cost basis you just calculated will now be important. In the third step of the cycle, you sell a covered call (CC).

You obligate yourself to sell 100 shares at a strike you choose (if, at expiration, the underlying’s price exceeds the strike’s price). It is “covered” because you were assigned earlier and own 100 shares, so all you need to do is sell the call. To begin this step, select a strike above the current stock price and ideally above your cost basis. By selecting a strike above your cost basis, even if the contract is exercised, you will be selling your shares for a profit. You are again paid a premium for this obligation. Like step 1, the further out your expiration is, the more premium you receive, but there are greater odds the stock might rise above the strike.


Step 4


This brings us to the last step where, like in step 2, three things can happen.

  • If the stock is above the strike at expiration, you will get exercised and must therefore sell 100 shares at the strike and start the wheel again at step 1.

  • If the stock is below the strike, the option/contract expires worthless and you can keep the premium (Every time you keep premium, subtract it from the total cost and calculate a new cost basis). Repeat this step until the shares get called away.

  • If the CC is at e.g. 50% profit, you can close early it by buying the call for less, thereby keeping some of the premium.

Once the shares have been called away, you can repeat the cycle from step 1. The three incomes generated are: the premiums from selling puts, the premiums from selling calls and the profit from selling the shares above your cost basis (capital gain).


If the shares pay dividends while you are selling CC’s, it’s a fourth income.

b. Risk / Profit / Loss

The max risk you have is limited. During the first steps, the max risk you take is the obligation to buy 100 shares at the put strike. Your max risk would therefore be for your underlying stock to lose the entirety of its value.You must also always have the sufficient liquidity/margin on hand during the process.


Secondly, after you have been assigned the shares, if the shares fall in price considerable below your cost basis, you are at risk of taking a loss. Therefore, keep selling CC’s above your cost basis (if possible) to further reduce it until your cost basis is ideally below the share price.

In terms of profit, the profit is fixed at each step. When selling CSP’s, and then CC’s, the max profit is the premium you received, which depends on the strike, expiration etc.

In addition, choosing a strike very far out of the money will greatly reduce your premium earnt due to the decreased risk. In the end it depends on how much risk you are willing to take and what you believe the underlying’s correct valuation to be.

Furthermore, it depends at what strike you sell the shares in step 4, and if that strike is above your cost basis or not.



c. Timeframe and its impact

As mentioned previously, if you sell a CSP or CC with an expiration further away, you will receive a higher premium, however, you run the risk of an event causing a sharp change in the price of the stock and not being able to sell CSPs at a strike price close to your cost bases when assigned.

A very short time frame of e.g. 1 week will pay very little premium, as the probability of not getting assigned/shares being called away is lower and there is less time value in the option contract (remember theta). Keep in mind that during periods of higher expected volatility, e.g. upcoming earnings dates etc. premiums may be higher, yet the stock may also make big moves, increasing your risk.

Important. Note: although the longer dates have higher percent profitability, repeated shorter dates earn more but you are at risk of the stock price going up and not benefiting from the same profitability on the same strike price (if the stock goes up your strike price will become out of the money and you will need to increase your strike to get the same profitability).



Advantages


This strategy is useful when you expect little price movement of the stock or expect it to rise slowly. Overall, low volatility periods are a better time to use the Wheel- although high volatility will boost your profitability greatly as you will be selling more expensive puts/calls due to the high implied volatility and therefore earn a much bigger premium. Pick stocks that have good balance sheets, cash flows, and if possible good dividends as these are more stable and less risky. This strategy pays consistent returns, and can therefore be used for income, as long as you have the necessary capital to cover your positions.


Disadvantages


When there is high volatility, for example during the current epidemic, markets often make big moves in either direction, so this strategy can be very risky as you may get assigned the stock at your strike, yet the stock has fallen below your newly created cost basis. It may therefore take a long time before you can sell the shares profitably again.

On the other hand you can also have a big opportunity cost if the stock moves up strongly as you’ll only make a limited profit compared to what you may have earned if you had bought share or a call. Moreover you won’t be able to sell calls at the same strike with the same profitability.

Note that you should always have the capital on hand to buy 100 shares at your selected strike when selling CSP’s, as otherwise you may have to borrow money to purchase the shares you obligated yourself to buy.



Example

Let’s look at an example. Assume stock X is currently at $150. To start the Wheel, you could sell a CSP with a strike of $125 as seen on the right. Let’s say selling the CSP pays you $100 in premium. If the stock remains above $125, your max profit is capped at $100 (the premium). The maximum loss you can incur is $12,400 [($125*100 shares) – $100 premium], which would require the stock to fall to $0. As seen on the graph, there is a breakeven point (BEP), which is calculated by subtracting the premium i.e. $100=1$/share from the strike, so BEP would be $124.

Let’s assume that at the expiration date the stock price is $120, you would now buy 100 shares of X for $11,900 (due to $100 premium) and proceed to sell CC’s. The cost basis of each share is therefore $119, so ideally you would sell a CC with a strike above $119. This time, let’s assume you sell a CC at a strike of $122 for a premium of $100 again, and at expiration the stock is at $121. Due to the stock being below the strike, you would keep the $100 premium and reduce your cost basis to $118. You sell a CC with a strike of $122 again, collect $100 in premium, but this time the stock is at $123 at expiration. As a result, you sell your shares for $12,300, add the $100 in premium from the CC, so $12,400 total.

In this example, you spent $11,900 when you were assigned the 100 shares of X, and sold them for a total of, including premiums collected, $12,400. You made a profit of $500 even though if you had outright bought 100 shares at $120 and sold at $123, you would’ve made $300.






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