The idea of perceived risks mainly scares fresh investors and traders: a constant, nagging reason not to jump into the stock markets. Fear for the safety of the capital invested could actually reach paralyzing levels and could cause some to stick with “safe” low-yield investments, hardly keeping pace with inflation. Such conservative approaches, as they are, tend to limit returns and hence do not maximize wealth over time.
However, the world of options trading contains good alternatives if one wants to take a view on the market, which can lend safety to approach in fetching consistent and attractive returns. It is not necessary that all options strategies are high in risk; there are some which are considered safer than traditional stock trading itself. However, the challenge in all this is to get these strategies appropriately enough to be in a position to apply them effectively.
Right now, in this article, we will give you a simple and low-risk investing strategy that uses options to give you steady returns with little risk. The “Wheel Strategy” provides a structured approach within an investment using cash-secured puts and covered calls that help you grow your investment portfolio with the safest manner possible.
Learning the Basics: Cash-Secured Puts and Covered Calls
Before discussing the Wheel Strategy, it’s necessary to learn its two basic ingredients: cash-secured puts and covered calls.
Cash-Secured Puts
This involves selling put options on a stock you wouldn’t mind owning. That is, by selling a put option you are agreeing to buy the stock at a predetermined price, known as the strike price, if the stock is less than that level at the time the option expires.
The “cash-secured” part of that is to suggest that you have enough cash in your account already to cover the purchase of the stock, in case the option is exercised. The beauty of it is that you get paid whether or not the stock actually falls to that level.
Writing Covered Calls
If you get put the stock, either because you were already assigned shares via a cash-secured put, or had bought shares first and learned about the strategy second, then you could sell call options against that stock. In other words, you would be agreeing to sell that stock at a specified price if it is worth more than that level at the time the option expires. Again, you are taking in some premium for selling the call, which adds to the income.
Step-by-Step: Implementing the Wheel Strategy
For instance, Wheel Strategy involves the use of cash-secured puts and covered calls in a cyclical manner to maximize the potential for returns while controlling risk.
Step 1: Selling Cash-Secured Puts
We will start off with an underlying you wouldn’t mind owning; let’s use Chevron (CVX). It’s a good company in a sector that, over the long term, most would agree is likely to have strong growth. Let’s say it’s trading at $158.69, and you are okay acquiring it at a small discount.
Accordingly, you sell a cash-secured put at the $150 strike price that expires in a month. This put option might have a delta value near 20, therefore it will provide an 80% probability that it will expire worthless.
Assume, for example, that you sell this put and collect a premium of $130. Keep the money—come what may. Keep the premium; in fact, if CVX stays above $150 to the option’s expiration, the put expires worthless and you bought to keep the premium and not bought the stock.
In other words, if CVX drops below $150, you’ve obligated yourself to buy 100 shares at $150 each. But you still keep the premium, reducing the effective purchase price to $148.70 per share.
Step 2: Sell the Covered Calls
If you’ve been assigned the shares, the next move is to sell a covered call. You sell a call with a $155 strike. At current market conditions, maybe you pocket a premium of $42 or so. If CVX rises above $155, your shares are “called away”; you sell your shares at $155.
Although you may not capture all of the upside, you will lock in a profit while keeping both the premiums from the put and the call options.
If CVX does not hit $155, you just keep the shares and the premium. You can then do this again—you sell another call for the next month. Over time, this generates a nice steady stream of income as these option premiums are collected again and again.
Step 3: Repeat the Process
That’s how this strategy gets its name—the wheel. In the event of your call option being exercised and your shares being sold, you go back to Step 1, selling cash-secured puts again. If your call option expires worthless, you sell covered calls against your shares. The strategy is circular as it continuously generates income whether the stock moves up, down, or sideways.
The Risk-Reward Balance
One of the greatest benefits of this trade is that it’s really the perfect mix between risk and reward. By selling an option that has a relatively low chance of expiring in-the-money (typically a ∼20 Delta), there’s a really good chance you’ll keep the premium without ever buying or selling the stock. On the rare occasions when you buy the stock, you do it at the current stock price instead of buying high.
Besides, this approach enables you to generate returns even in a stagnant or mildly bearish market—a situation in which mere stock holding would be without profit. Those small chunks eventually add up into a possibly higher return than that of traditional buy-and-hold strategies, with much less volatility and risk.
Real-Life Example: Chevron’s 12-Month Wheel Campaign
So, to show you how this Wheel Strategy actually functions, we’re going to do a twelve-month campaign of Chevron Stock.
- July 2023: Sell a 150-strike put, collecting $130. At option expiry, CVX closes at $158.69 so the put expires worthlessly and you keep the premium.
- August 2023: Sell another 150-strike put, collect $163. The stock is $166.50 at the close. The option goes out worthless, again expanding your profits.
- September-October 2023: Continue selling the put premium and collecting premiums without being assigned shares.
- November 2023: CVX closes below $150, and you’re assigned 100 shares of stock at the price of $150 each.
- December 2023-March 2024: You are writing covered calls against your stock. Come March, the stock rallies above the $155.00 level, and you get taken away, making the money.
- April-July 2024: Start over with selling cash-secured puts as you did at the beginning and continue following the cycle. After the 12 months, you have collected premiums of $1,659 along with any dividends paid while you owned the shares. So even though CVX ended a little higher than where it began, the Wheel Strategy picked up an 11% return at the close of the trade—really kicking the butt of the stock’s 4.25% return through price appreciation alone.
Conclusion
The Wheel is a great strategy for a beginner investor or for those who would want a low-risk way of investing in each trade. With that in mind, you sell cash-secured puts or covered calls to give influential involvement in, or profits from, the trade while at the same time reducing your exposure to any market volatility. This is not a trade to hit a home run but rather to steadily build up returns in the same manner, time and time again.
The Wheel Strategy hinges on predictability—the option premiums—and the natural ebb and flow in stock prices. It is a simple but very effective way to make your money work harder for you and set a path for consistent returns with significantly reduced risk.
For experienced traders or new to the options game, contact us to discuss The Wheel Strategy, which could strengthen your opportunity or overall position within the marketplace. By including this easy, low-risk investing approach in your portfolio, you can venture into the markets without fear and develop wealth over time.