By Lawrence G. McMillan
Recently, I have been seeing some references to the “wheel” strategy. Of course, they come with all kinds of accolades about how you can’t lose, etc. I thought it might be a good time to discuss that strategy.
If we ask AI or Google “what is the wheel strategy?” we get back an answer similar to this:
The strategy consists of the following steps that are repeated in a cycle:
First, sell cash‑secured puts (CSP): You start by selling an out‑of‑the‑money put option on a stock you would be comfortable owning at the strike price. A “cash‑secured” put means you have enough money in your account to purchase 100 shares of the stock if the put is exercised.
Outcome 1 (ideal): The stock price remains above the put’s strike price, the option expires worthless, and you keep the premium. You can then sell another cash‑secured put to continue generating income.
Outcome 2: The stock price falls below the put’s strike price, and you are assigned to buy 100 shares at the strike price. At this point, the “wheel” turns to the next step, selling covered calls.
Sell covered calls: Once you own 100 shares, you can sell a covered call option against those shares. The goal is to collect more premium while you own the stock.
Repeat: If your shares are called away, you can use the cash to start the cycle over by selling a new cash‑secured put.
Pros and cons
Pros:
- Generates consistent income: You earn premiums from both the puts and the calls, providing a steady income stream.
- Acquire stock at a discount: The premium collected from the initial put sale reduces your effective cost basis if you are assigned the shares.
- Capitalizes on time decay (theta): By selling options, you benefit as they lose value over time.
Cons:
Capped profit potential: Your profit is limited to the premiums collected and any capital gains up to the covered call strike price. You miss out on potentially larger gains if the stock soars.
- Unlimited downside risk: If the stock price plummets after you’ve been assigned, your potential loss is significant.
- Requires significant capital: You must have enough cash to cover the cost of buying 100 shares for each put contract you sell.
- Best for stable markets: The strategy can be negatively impacted by high volatility or a rapid, sustained market downturn.
OK, that’s the end of the AI/Google summary. Let’s see what’s really going on here.
Proponents say this is a systematic approach, since the strategy has a clear set of rules, which can help remove emotion from trading. But does it? Exactly what striking price call are you going to sell after you’ve been put? Here’s a scenario that they don’t normally describe...
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