The Few Times Options is Safe: Detailed Guide on The Wheel Strategy

Recently, there’s been an increasing amount of hype around options trading especially in things like buying TSLA calls and sometimes SPY puts. You may have already made up your mind on the fact that options trading is only for people willing to either go big or go home (many times going home). Let me tell you, there is a more patient way of going about this besides going all in using your CERB money.

This is a great options strategy because EVERY scenario has been accounted for, which makes it safe and reliable. Of course, you’re trading off the huge gains that you could get from just doing regular buy calls but once you get into the rhythm, you will make consistent profits. So there are a few parts I did add to further your intuitive side on understanding options but probably nothing you can’t handle.

Although this is more advanced for beginners, there’s a lot of concepts that will help in future options trading. I will assume you understand the very basics of how calls and puts work for both writing and buying as well as when a contract is in the money vs out of the money.

The Wheel Strategy, some people call it the Triple Income Strategy, comprises of six steps and after you finish them, you rinse and repeat. Which is where the name, “The Wheel” comes from. Here are the steps:

1. Sell cash-secured put (CSP)
2. Avoid assignment and roll
3. Get assigned after it not being worth
4. Sell covered call (CC)
5. Avoid assignment and roll
6. Get assigned after it not being worth

Now the only “ingredients” that you need is being able to afford 100 of the underlying stock and it’s key that you like the stock and believe it’s going to go up in the future. The other is that since CSPs and CCs are considered level 1 options strategies, you would need approval from your broker.

For me, this is the model I’m going to be using for doing The Wheel.

• Good company that has solid cash flow (You believe it’s bullish in the long term)
• Priced around 10–50 bucks (Don’t want to lock up too much as collateral) If maximum stock price is 50, then maximum collateral is $5000
• I also want the time to expiration (TTE) to be 30–45 days as time decay accelerates

• I also aim for delta to be around 0.3 which gives me a 70% chance of it expiring out of the money (OTM) which I think is a good balance.

So delta can be thought of as the change in the price of the option given a $1 change in stock price. If delta is 0.3 and stock price goes up by $1, the options price will increase by 0.3 x 100 if it’s a call. It will go down by 0.3 x 100 if it’s a put. You can also think of it as the chance of it being in the money (ITM) before expiration as the higher the delta, the more chances it has of increase/decreasing. Now, because it has a 30% chance of being ITM before expiration it also means that it has a 70% chance of being OTM during expiration. Remember, we want it to expire OTM because then it expires worthless and we won’t have to buy those overpriced stocks! So in the Robinhood platform, you’ll notice that the percentage of profitability that you see is similar to the delta that they give.

So the range in delta depends on if it’s a call or a put. Calls can only be between 0 and 1, as options price increases as the stock price increases, while puts can only be between -1 and 0. Now what would happen if the deltas reached -1, 0 or 1? Well, they don’t give you the choice to do so but theoretically having a delta of 1 means you have a 100% chance of being ITM. Which means it’s very deep ITM and you’ll basically be simulating yourself holding 100 of those actual shares i.e. as the stock price goes up by $1, since delta is 1, you’ll be getting $100. Of course the premium would be ludicrously high and if we assumed the market was actually perfect, there would be no difference in owning either.

So another concept you have to know is theta which is time decay, the part that depreciates the value of an options contract. Remember, time decay works in your favour when you’re writing options as you want it to decay as fast as possible so that the option expires worthless. If theta is 0.10, the price of the contract depreciates by $0.10 x 100 per day and will ramp up within the last 30 days.

So premium is what matters to us the most as that’s how we’re going to be making money from doing the Wheel Strategy. A premium is what the buyer has to pay to the seller to have the right of assigning/exercising the option. The premium is made up of two things, intrinsic and extrinsic value. Intrinsic value is the money you get immediately when you exercise it. Say you have a 50c and it’s ITM so the current price is $55, that option has $5 of intrinsic value.

If it sells for $7.50, the extrinsic would be $7.50 — $5 = $2.5. Therefore, a DEEP ITM option has the least theta decay since more of it is made up of intrinsic value. Extrinsic value is made up of time to maturity (TTM) and implied volatility. So that means the part that theta decay/time decay eats from a premium’s value is the TTM so the closer an option expires the faster it decays. As the expirary date gets closer, there’s also a lesser chance of it being volatile so theta decay implicitly affects implied volatility as well.

Now since we’re going for delta being 0.3, most of the time the contract will expire worthless meaning that you don’t lose anything and keep the premium that they paid. You would then just repeat the same step to get more premium. Now what would happen if it was close to ITM or is already ITM and you were scared it might get assigned? Then you would buy-to-close and roll it further OTM so that it’s in your favour.

So the act of rolling a contract is when you buy-to-close a contract and then get a new contract and make it further OTM. This is when you’re buying the same contract, most likely from someone else and at a higher premium, and this would mean that you’re now a buyer as well. So let’s say person A is the person that bought your contract, so you’re the seller in that case. When you buy-to-close to person B, you become the buyer and person B is the seller. So traditionally, you can just exercise YOUR contract immediately when person A exercises their contract and you would act sort of like the middle-man. But, brokerages will just void your responsibility from this whole interaction and just tie person A with person B. Another way of thinking about it is that it’s a closed system where it’s only person A and you. When you buy-to-close you get your contract back which means you’re the seller as well as the buyer and anytime you exercise it, you net 0.

So now that you’ve rolled the contract OTM, you won’t have to worry about it getting assigned but you pay a premium for avoiding this. The reason is since it was already ITM, for you to buy-to-close would cost more than when you originally paid since ITM contracts are more expensive than OTM contracts as the intrinsic value is more while everything else remains constant so you’ll be at a net loss.

So for rolling a contract, you can turn two valves, the expiration dates (outwards or inwards) as well as the strike price (up or down). So there’s really four choices you can do, here is what you should do for each scenario. So no matter what, rolling it outwards or inwards affects calls and puts the same way (inwards as making the expiration date closer and vice versa). Rolling it up and down, moving strike price up and down respectively, depends on if it’s a call or put so we’ll use ITM and OTM to avoid confusion.

[Profitable] (More premiums but higher chance/risk of being called)

Rolling ITM: You’re making it closer to being called but you’re rewarded more premium (Only do this if you want to get called or you’re so confident that it stays OTM. i.e. If somehow there’s a huge change in the stock price and delta is 0.05, that’s way too safe and if you’re model is you want delta to be 0.3, you can sacrifice a bit of the risk in exchange for more premium.

Rolling Out: Again, you’re confident it stays OTM so you’re allowing more time which means more risk but higher premiums/rewards.

[Favourable] (Less premiums but higher chance of success)

Rolling OTM: Less chance of you getting called since you’re making the strike price further OTM

Rolling In: Less chance of it going ITM since exp date is closer as well as faster theta decay

Selling the Cash-Secured Put

So recall, selling/writing a CSP is where you’re giving someone a contract that forces you to BUY the 100 stocks from them if ever exercised. They could also not exercise it and in that case, it expires worthless. So they will normally exercise it if he strike price is above the current price i.e. they make you buy those stocks at a premium. For example, AAPL is now at 110, but strike price is 120 so they force you to buy the $120 AAPL stocks from them. Since it’s cash-secured you’re basically locking up $120 x 100 as your collateral in the event that you do get assigned.

So here’s the procedure for EVERY case that will happen.

I. Expires OTM — Sell another CSP to collect more premium!

If it expires worthless, where the stock price is more than the strike price just sell another CSP and calibrate the delta if it skews away from 0.3.

There is a more advanced step where if it expires so far OTM for whatever reason, you can buy-to-close it and you’d basically be making a profit. The reason is when you sold your original contract, you get some premium, but since it became so far OTM when you buy that contract to make your position flat and reset, you’re doing so at a cheaper price because recall, the more ITM a contract is, the more expensive it gets. I normally will buy-to-close if I have a 50% profit.

II. Goes towards ITM — Roll or get it exercised!

So there are two scenarios that can happen. If it’s going towards ITM and it hasn’t been exercised and you want to keep going just roll the contract.

If it goes ITM and it gets assigned, this is where the next phase of the wheel occurs. So normally when you roll it, you’re incurring a small loss to get back into the game. If this happens a few times you’ve most likely either got very unlucky or you calibrated your delta wrong. The odds of the contract being ITM three times is 0.3 x 0.3 x 0.3 = 2.7%. So remember you’re collateral for CSP only gets freed when your position is flat (no contracts are present for the CSP). So if you keep rolling your contract out or OTM eventually you may find that it’s not worth it anymore to get that extra little bit of premium in exchange for the collateral that you’re using for the CSP. You can find if it’s worth it or not by doing premium / collateral locked up to find your return. Eventually you will get assigned and that’s when you’re forced to buy those 100 shares!

Selling the Covered Call

Selling a covered call (CC) means you’re writing a call while you own 100 of the stocks that you used to sell the call with. The person that you sold your contract to will exercise it if the stock price is greater than the strike price, they will force you to sell those 100 stocks to them at the strike price and that would mean they would profit if that is the case. Here’s an example:

If you sell at 100c, and currently it’s at $95 so it’s OTM and later it ends up going to $105. When they exercise it because it’s ITM, they’re forcing you to sell those $105 stocks that appreciated in value to them for only $100. Of course, you make a profit of $100 — $95 = $5 but you would lose out on the gains when the stock goes from $100 to $105 or anything beyond that. This is why selling calls will cap your gains.

Now the instructions are the same as when you sold the CSP. Delta is around 0.3 and TTE is 30–45 days out. So remember, your delta does not stay constant at 0.3, it changes based on ever new day. This is where gamma kicks in but we won’t discuss that in this guide. Of course you can’t adjust it when your contract is active so you can only do it during the down-time when you buy-to-close or when it expires worthless.

Now, here’s where adjusted cost-basis comes in. So selling a CSP also serves another purpose, which is to make the price of you buying that particular stock cheaper! Since if you do get assigned, you will buy the stock at a cheaper price. Technically you can say it wasn’t cheaper as you’re buying the stocks above the strike price but originally, the only way you would’ve bought it was if it did go down, so you can think of that as a win-win scenario. Now those stocks are cheaper than when you bought it at the strike price since any time you sell, you are guaranteed a premium that can’t be taken away, so you can include your premium into the price of the stock as well. Here’s an example:

Say you sell a CSP for NIO at 40p and it was originally at 45 but then falls to 38. When they exercise it, you’re buying a $38 stock for $40 where you’re buying at a premium. But remember that you always keep the premium that they pay you. So if the premium was $1.00 so overall, it’s $100. Now you paid $40 x 100 = $4000 for NIO but because you paid the premium, it’s actually $4000 — $100 = $3900 or $39/share instead of $40. So the adjusted cost basis is the strike price minus premium.

Now when sell your CC, most of time you want to sell it higher than $39, that way when you do get called, you’ll guarantee a profit no matter what. Sometimes, it would be better to just take a small loss so that you won’t lock your collateral for even longer so it always depends. But if you sell it higher than your adjusted cost basis, if you get exercised you profit and if it doesn’t get exercised, you also profit from the premium you gain and then you just repeat!

Remember, the more times it expires OTM, the more premiums you will get and that would mean a lower adjusted cost basis and you can take that into account and sell your CCs for even lower. So after every run through the wheel strategy, your adjusted cost basis changes. So the scenarios are similar to the CSP.

I. Expires OTM — Sell the CC again and collect more premium

So again, you can either let it expire or if it expires so far OTM, then just buy-to-close to get the profit and go again.

II. Goes towards ITM — Roll it out or let it get assigned

So you can either roll it out to collect more premium or if it starts doesn’t seem worth it anymore, you can allow it to get assigned and sell the CC preferably above your adjusted cost basis.

REPEAT!

So the main trick in doing the wheel strategy is just being patient and knowing how to manage your positions for each scenario this is where most losses happen. The main thing is you need to buy a good stock that you like! If not, everything else falls apart.

Tips:

1. If rolling the CSP isn’t worth anymore, just let it get assigned. If you buy-to-close it early, when it’s ITM you may have a large loss! Let it play out, that’s why we have the 2nd half of the strategy. This is the same as for CC as well. Don’t close it too early or you’re going to be paying a huge premium to flatten your position.
2. If the stock keeps dropping, it shouldn’t be an issue as you believe it’s very good long term. Don’t do anything drastic, just let it play out to avoid such a huge loss and if this does happen, just find another stock. This shouldn’t be a problem as doing due diligence on the stock you’re using is KEY.