Introduction: What is The Wheel?
The wheel strategy involves two trades: the cash-secured put (CSP) and the covered call (CC). This is a popular trading strategy used by beginner options traders. It’s so popular, in fact, that there are entire communities (such as the ThetaGang subreddit) where the wheel is their main strategy. Here’s how it works:
- Sell a cash-secured put option on a stock. This means you receive a premium in exchange for the obligation to buy the stock if the option is exercised.
- If the option is not exercised, you can sell another put option, generating more income.
- If the buyer exercises the option, you have been “assigned.” You purchase the stock at the strike price and can hold it long-term.
- Once you own the stock, you can sell a covered call option. This means that you receive a premium but are obligated to sell the stock if the option is exercised.
- If the option is exercised, you sell the stock at the strike price, generating a profit. If the option is not exercised, you can sell another covered call option, generating more income.
Later in the article, we’ll discuss how to identify stocks best for trading the wheel strategy.
Why Does The Wheel Work?
Overall, this is an excellent strategy for two reasons. Firstly, stocks tend to go up over time, so a bullish strategy profits over the long run. The second reason is that options’ implied volatility (a way of measuring options prices) is generally too high. This results in options being assigned less often than you might mathematically expect from option prices. Losses from option assignments are also less than the market prices would imply.
Why Do Stocks Go Up?
Stocks go up in order to compensate investors for the risk of holding equities.
The Equity Risk Premium refers to the extra return an investor receives for investing in stocks rather than bonds or other less risky investments. Equity investors have exposure to market downturns, changing interest rates, and the possibility of bankruptcy, but by doing so, investors are effectively helping companies acquire funds for their operations. Investors are then rewarded by owning a portion of the growing company.
Why is Implied Volatility too High?
Insurance is a mechanism by which risk is transferred from one entity to another, typically in return for a payment known as a premium. Insurance companies make money by taking risks from individuals and businesses in exchange for premiums. For instance, when you own a vehicle, you can purchase car insurance that protects your asset against losses due to theft or an accident. Each year, the insurer collects premiums to provide financial protection should such unfortunate events occur. In these cases, the insurance company pays compensation to make the policyholder “whole” again.
Options are a form of financial protection that allow the transfer of risks from the buyer to the seller. Just as auto insurance is used to protect one’s vehicle, options can be used to protect one’s investments in stocks, indexes, or futures. Stockholders can purchase a put option to insure themselves against losses below the strike price. In contrast, short-sellers can purchase a call option to insure themselves against the possibility that the stock increases in value.
Most buyers of insurance know that they’ll end up paying more in premiums than they’ll use since houses rarely burn down and cars rarely crash. However, insurance buyers are willing to overpay in order to have peace of mind should they ever need it. Option buyers are the same way. The variance risk premium (VRP) describes how implied volatility tends to be greater than the subsequent realized volatility. This phenomenon presents an excellent opportunity for those willing to accept the risk of selling volatility by writing options contracts and collecting premiums.
The Greeks of The Wheel
Investors trading stocks can describe their position as “long” or “short.” We can infer that if an investor is “long” a stock, they benefit from the asset appreciation. While the same idea applies to options, there are a few more factors: volatility and time decay. Rather than just long or short, we can describe our position using the Greeks, the most common being Delta, Gamma, Theta, and Vega.
Delta
The wheel is “long” delta – it benefits from the underlying stock appreciating in price. This is because an increase in the stock price will increase our chances of our puts expiring worthless and benefit our stock holdings when we have covered call positions.
We can say that the wheel has delta risk; we are bullish and lose money if the stock price moves against us.
Gamma
The wheel is a short gamma position; as the stock price moves, the delta of our position changes in the wrong direction.
Our cash-secured puts earn less profit for every dollar the stock continues to rise, as our maximum profit is the premium received. Our covered calls also have a profit cap: any gains past the strike price of the stock are lost as the stock is called away at expiration. As the stock price increases, our delta approaches 0, and we no longer profit from further appreciation.
However, when the stock falls, our losses compound. As the stock falls and our puts end up in the money (ITM), it becomes more likely that we will be assigned stock at the strike price. As such, our position begins to act like 100 shares of stock. Similarly, as the stock price falls away from the strike price of our covered calls, the value of our call decreases, and eventually, our position is not too different from just holding 100 shares of stock. As the stock price falls, our delta approaches 100.
We can say that the wheel has gamma risk; moves in the stock price hurt us because we don’t participate in much of the asset appreciation, but we bear the full risk of the stock price falling.
Theta
Because the wheel is short gamma, an equivalent stock position will gain more when the stock increases but lose less when the stock falls. This is because we have less positive delta when the stock is rising but more when the stock falls.
Because of this major drawback of being short gamma, option sellers demand that buyers not only pay the option’s intrinsic value (the profit if an option was immediately exercised) but also an extrinsic value. This value decays as time passes until only an option’s intrinsic value is left at expiration.
When we trade the wheel, we are option sellers. This means we benefit from this decay in the option’s value. We are long theta.
Vega
The wheel is short vega; we benefit from implied volatility falling. When the market expects little to no stock volatility, they realize that options only have a small chance of being ITM by the expiration date and are unwilling to pay much extrinsic value. On the other hand, when the market expects an increased level of volatility, options become more valuable as the extrinsic value of an option increases.
When Should We Trade The Wheel?
From the Greeks, we can judge that we should trade the wheel under certain conditions:
- We are bullish on the stock.
- We do not think the stock’s value will fluctuate by too much.
- We believe that implied volatility will fall, or at least will not rise.
Being Bullish
Equities generally go up over time. In the short term, though, it’s pretty hard to determine the direction of stocks, especially in the short term. For example, the market prices in most technical indicators and fundamental data, since that data is public and available for everyone trading against you.
However, sometimes there is information that the market fails to price in. For example, a lot of academic literature discusses the Post Earnings Announcement Drift, a phenomenon where information from earnings announcements takes a while to be fully priced in. If a stock jumps after earnings, there’s a decent chance it continues drifting in that direction for several days.
Being Short Volatility
Selling options is profitable when implied volatility is higher than the stock’s future volatility, as options are ITM less often (and less ITM when they are) than market prices assume. Luckily, implied volatility tends to be a little too high on average.
In the short term, though, there are a few ways to find overpriced options. Unfortunately, IV Rank or Percentile may not be one of them. These metrics measure IV relative to its historical implied volatility, but it doesn’t tell us whether it’s too high or too low. Often, the stock’s actual volatility is higher than the implied volatility during high IV and IV Rank, and option sellers lose. Stock volatility can also be lower than implied volatility during low IV and IV Rank times. There are exceptions, of course. For example, implied volatility tends to be too high over events such as earnings and FOMC announcements.
Some data analysis and in-depth research can uncover situations where IV is too high. For example, if an ETF’s implied volatility rises but the IV of its constituent stocks remains the same, this might be a good time to trade the wheel.
What DTE Should I Trade?
It’s common for ThetaGang and other retail trading communities to recommend trading 45 DTE options, but I prefer 30 DTE and under. Here are a few considerations to consider when picking your expirations:
- Implied volatility, realized volatility, and the stock direction determine the profitability of the wheel, not time to expiration. Find the expiration where the implied volatility exceeds your realized volatility forecast.
- Theta and gamma both increase as the time to expiration decreases. While the gamma risk increases, the theta you collect also increases. Traders who open positions in short-dated options may want to open smaller positions to reflect the increased risk.
- Longer-dated options (especially those that expire after the first monthly options) tend to have worse liquidity. It costs you more to enter and exit trades as the bid-ask spreads are wider.
What Strikes Should I Trade?
The strikes you choose will help determine the greeks of your position. For the wheel:
- The lower the strike of your call or put, the higher your delta.
- Gamma, theta, and vega are the highest at the money. This is because most of an ITM option’s value is intrinsic value, and far OTM options aren’t worth much in terms of the dollar amount.
- For equities, OTM puts tend to be more expensive due to the volatility skew. However, equities have a negative “spot/vol correlation”: volatility increases when the spot price (stock price) falls. OTM puts will get shorter vega as the stock falls and implied volatility increases, hurting your position. On the other hand, OTM calls tend to be cheaper, so call sellers receive a smaller premium. However, implied volatility drops when the stock increases, which benefits the position.
Other Considerations
- Diversification: Just as you wouldn’t hold one stock position, make sure any given wheel trade isn’t too large.
- Position Management: The 50% rule is only for beginner traders; this rule implies there is no “optimal” time to close trades. Several traders could have sold the same puts at different prices, and the 50% rule would recommend they close at different times. Traders should close their trade whenever they are no longer bullish on the stock or want to be short volatility. Closing earlier leaves money on the table, but leaving positions open for too long exposes you to unnecessary risk.
- Put Call Parity: Covered calls and cash-secured puts are the same trade. In both cases, you are left with 100 shares of stock at expiration if the stock is below your strike price, and you are left with no position if the stock is above your strike. The only difference is that traders typically sell covered calls with strikes above the stock price and puts with strikes below the stock price.
- Variations: If a trader wants to be short volatility but has no opinion on the direction of the stock, they can hedge their short put by buying enough shares to hedge their delta. This trade will look similar to the straddle. If a trader is bullish but has no opinion on the volatility of the stock, buying shares outright may be a better trade.
Conclusion:
In conclusion, the wheel is an excellent strategy for beginner traders as it has long equity and short volatility – both profitable over time. However, the wheel is not as straightforward as it appears on the surface, as there are many factors to consider before placing a trade, including volatility and skew.