Wheeling and Dealing: A dive into options trading and the Wheel Strategy

Often dubbed the “Triple Income Strategy”, The Wheel is an active options trading strategy, designed to generate steady income with the potential to acquire discounted stock. It involves the systematic approach of selling options, utilising two well-known option strategies known as the Cash Secured Put and the Covered Call. This strategy can be particularly appealing for investors with a rudimentary knowledge of options markets who want to capitalise on market volatility while effectively managing risk on a quality share or ETF.

Understanding the basics

An exchange-traded option is a financial derivative giving the holder the right, but not the obligation, to buy or sell an underlying security (e.g., shares or ETF units) at a specified price (strike price) on or before a certain date in the future (expiration date). Option trading strategies can be tailored to hedge risk, speculate with leverage, and generate passive income to maximise yield. The value of an option contract is derived from the following variables:

• Intrinsic value: The difference between the strike price of the option and the market (spot price) of the underlying.
• Time to maturity: The further away the expiration date, the higher the value of the option as the probability of the option landing “in the money” (ITM) increases.
• Volatility: Underlying securities with high implied volatility generally have higher option values. Similarly, higher volatility improves the probability of an option expiring ITM.
• Interest rates and dividend expectations.

Options exist in two formats:

• A call option gives the buyer of the contract the right to purchase the underlying. The seller of the call option contract must be prepared to sell the underlying asset if assigned.
• A put option gives the buyer of the contract the right to sell the underlying. The seller of the put option contract must be prepared to buy the underlying asset if assigned. 

The assignment refers to the process of exercising the option contract. Any ITM open positions that are not closed before expiration (e.g., buying or selling back the contract) will be exercised, resulting in delivery of the underlying asset. Most contracts are denominated in “lots” representing 100 units of the underlying (e.g., 1x AAPL option contract is equivalent to 100 shares of AAPL stock).

Learn to 'wheel' in six steps

Example - a new spin on bonds trading

Step 1: Pick your underlying.

At the time of writing (July 2024), Saxo predicts the United States to cut interest rates twice this year. This will cause the value of US Treasury Bonds to rise. To expose our portfolio to this anticipation, it would be appropriate to trade the iShares 20+ Year Treasury Bond ETF (NYSE: TLT), as we would like to acquire it at a cheaper price and hold.

Step 2: Sell cash-secured put ($ = USD).

• Spot price for TLT = $92.52 (all figures from US market close on 23/07/2024).
• Sell a 30 DTE (days-to-expiration) OTM put option with a strike price of $92. This generates $111 of premium to keep. To "cover" the position, $9,200 ($92 x 100 ETF units) cash needs to be ready to deploy in the event of assignment.
• A $111 premium on this 30-day position on $9,200 will create an effective annual yield of 14.47%.

Step 3: Manage CSP position and assignment.

Step 4: Hold underlying and sell covered calls.

• After assignment, you now own 100 units of TLT. You are subject to market risk which entails capital gain or loss, and potential distribution payments.
• Sell a 30 DTE OTM call option with a strike price of $93.50. This generates $105 of premium to keep. You are completely covered as you hold the 100 ETF units in the event of assignment.

Step 5: Manage CC position and assignment.

Step 6: Repeat steps 2-5. Please note the above example excludes brokerage and exchange fees.

Benefits of the Wheel Strategy:

• Income Generation: Provides a consistent stream of income through option premiums, making it attractive for investors seeking to improve yield. 
• Risk Management: By selling options you are willing to own, you mitigate some of the risks associated with market volatility. 
• Potential discounts: you have the option to purchase an underlying at discounted rates. 
• Flexibility: The strategy can be adapted to different market conditions, underlying's and preferences.

Risks of the Wheel Strategy:

• Market risk: Like all strategies, the wheel carries market risk as stock prices fluctuate. 
• Volatility spikes and opportunity costs: significant volatility jumps could cause you to acquire stocks at a premium or sell at a discount. Managing and monitoring volatility levels is critical. 
• Assignment risk: You must always be prepared to face assignment when selling options, meaning you must have the liquidity to finance the CSP and the right number of shares to manage the CC. 
• Time and effort: The wheel is a highly active strategy; it takes time and many reiterations to perfect, so be prepared to put in the work. 

Other Wheel Strategy considerations:

1. Purchasing the underlying in a falling market: Always trade something on which you are long-term bullish, meaning you are willing to bear short-term market corrections. Continue to sell CCs to improve your yield and reduce capital losses.
2. Holding cash in a market rally: Continue to sell CSPs and ride the rally up. Consider rolling up the strike or rolling into a new expiration date.
3. No assignment: roll into a new contract expiration and keep collecting premium.

The Wheel Strategy offers active investors a structured approach to generate income and acquire stocks at potentially favourable prices. By systematically selling cash-secured puts and covered calls, investors can capitalise on market opportunities while managing risk. As with any investment strategy, it is crucial to conduct thorough research, understand the underlying assets, and align the strategy with your financial goals and risk tolerance. Whether you are a seasoned trader or a novice investor, the Wheel can be a valuable addition to your options trading toolkit.