When dealing with short term price fluctuations or the lack thereof the use of options is a great strategy. When you are more of a long-term investor the use of options finds less of a place in your trading. There are LEAPS (Long Term Equity Anticipation Security) are options that have longer maturities than your standard options. LEAPS trade like a standard option but have maturities out to three-years. These options can be used by the longer term investor who thinks the price may rise (buying calls) or price may fall (buying puts). However, one of the advantages of being a longer term investors is the collection of dividends which is lost when trading options. Option holders do not get to collect dividends.
Instead of trying to use LEAPS an investor might take their long stock position and sell covered calls against it. This is a great strategy because it allows you to hold your long position, collect your dividends, and collect extra income by selling calls. The only real downside here is that some of your stock may get called away because your underlying runs above your short call position. This, of course, is something you are okay with when selling covered calls.
The problem with selling covered calls on all your long stock positions is that you have to have the long stock positions to begin with. What we need is a system that can pay us to take a long position, allow us to collect our dividends, and also pay us to close out the position. Luckily the Wheel Trade will meet all those requirements for us.
What Is The Wheel Trade
The Wheel Trade allows us to collect a long stock position, earn dividends on that position and then earn more premium by selling calls on that position.
The start of the trade does not begin by already holding long stock but by selling short puts to collect the stock. Our short puts won't be margin trades but cash secured short puts. That means that this will work in a portfolio that doesn't have margin. It does, however, mean you need enough cash in your portfolio to buy the underlying position. Since you are not using any margin this can be a great strategy to work into your IRA and other retirement accounts.
A short put gives you the obligation to buy the underlying if your underlying falls below the strike price by expiration. A short put will be automatically assigned if it is one-penny in-the-money at expiration. Early assignment will be rare but can happen from time to time. If you are assigned you will be forced to purchase the underlying at the strike price.
Here is our example explaining a short put:
The Option Prophet (sym: TOP) is trading at $50 and we short the March 45 Put for $4.00. If TOP falls to $43 at our March expiration we will be force to purchase 100 shares of TOP at $45 (our strike price). The total cost of our purchase will be:
100 (shares) x 45 (strike price) - 400 (option premium) = $4,100
Since we have received some money from selling our option it lowers our cost basis. Without the option our cost basis would have been $45, but with the put sale our cost basis is now $41 (4,100 / 100). You can begin to see how advantageous it is for us to start selling put options to build our stock positions. We are able to get the positions we want on sale. The downside is that if our underlying tanks we will still be forced to buy the position at our strike price. This could start us heavily underwater. We will address this issue in a minute.
Once our put gets assigned we are now holding long stock. We don't want to keep this long stock in our portfolio so we start selling covered calls on it. A covered call is just a short call while holding the underlying. When you are short a call you have the obligation to sell the underlying if the underlying rises above your strike price by expiration. Just like a short put, a short call will automatically be assigned if it is one-penny in-the-money at expiration.
Our example explaining a covered call:
We are holding 100 shares of TOP at $45 and sell the March 50 Call. TOP makes a nice rally and is now trading at $55 by our March expiration. Our 50 Call option is now in-the-money at expiration so we get assigned and forced to sell our shares at $50 (the strike price). The downside to this trade is now obvious. Even though our underlying ran to $55 we were still forced to sell at $50 which caused us to miss the rest of the run up.
So now we have the basis for a Wheel Trade: sell a put, receive the stock, sell a call, and sell the stock. Now that we have basics we need to build the strategy.
Which Stocks Make The Best Candidates
There are several groups of stocks that are going to make the best candidates for the Wheel Trade. The first group is our indexes. Indexes and more specifically their ETFs (SPY, IWM, QQQ, DIA) work well because their liquid, have a lower volatility, pay a dividend, and generally go up in the long term. These are all great qualities with the only downfall is that they can be pricey. Most of these ETFs will cost over $100 a share so you will need a large portfolio to successfully trade this strategy.
Our next group of stocks we want to use the Wheel Trade on is stocks we don't mind owning. You should never use the Wheel Trade on a stock that you don't want to have in your portfolio. There can be times when we are not able to get rid of the underlying so it could sit in our portfolio for awhile. You don't want to be forced to hold a position you hate. It won't be good for you or your portfolio. Taking positions you like are the best stocks to trade. If you like these stocks fundamentally and believe they will move higher over the long term they will work well for the Wheel Trade.
The last group of stocks we want to focus on are our dividend stocks. Using this strategy does not guarantee you are going to collect the dividends they offer. After all there will be times when you are selling puts to get into the stock and could miss the ex-dividend date. There will be times when you are in the underlying while it is going over its ex-dividend date which will allow you to increase your return by collecting the dividend. If you can combine your favorite stocks with stocks that earn dividends you are going to set yourself up nicely.
If given the choice between a high volatilty stock and a low volatility stock choose the low volatility stock. That might seem counter intuitive since a higher volatility stock will give us better premiums but that also means realized volatility will be high. Realized volatility is high when the underlying is moving around a lot and that can be troublesome for our Wheel Trade. There are really two things we don't want this trade to do, run up a lot or fall a lot. In fact, if we never got assigned on our shot puts that would be ideal. It would be much better to continue shorting puts and collecting premium without ever taking a position but that is the perfect world.
Rules For Using The Wheel Trade
Now that we know the basics of the Wheel Trade and the types of underlyings we want to trade in the strategy we need to build the specifics of our strategy. We are going to break each section down separately so we can understand each concept easier.
When shorting puts we can either short the Weekly Options or the Standard Monthly Options. Weekly Options give us the advantage in that they are going to be more dynamic. There will be a lot more action happening with Weekly Options because of the shorter time frame. This also means you are going to have to be more active in managing this strategy. You will have a lot more options to have to sort through plus the chance of being assigned will come up a lot quicker.
Using Monthly Options will slow down the process and make the overall strategy easier. The chance of assignment will only come on the third Friday of the month as opposed to every Friday of the month. This means the constant process of getting in and out of positions will happen more slowly. The premiums in Weekly Options will be lower than Monthly Options but there will be more of them. You should be able to receive more premium using the Weekly Options, but your premium will come as one lump sum with the Monthly Options. How active you want to be managing this strategy is the determinant on which expiration you use, Weekly or Monthly Options.
Now that we know which expiration to use we need to decide on which strikes to use. Strike selection will be the same no matter what expiration we decide to trade. When selling our put options we want to go one strike out-of-the-money. If our option gets assigned we move on to our covered calls but if not we will sell another put option one strike out-of-the-money. Continue to do this until you get assigned on the stock.
When running this strategy you need to keep track off all your premiums, this is key. This is what we mean, if you have the following trade log:
Short TOP January 25 Put for 3.00 (expired worthless)
Short TOP February 30 Put for 2.00 (expired worthless)
Short TOP March 35 Put for 4.00 (expired worthless
Short TOP April 40 Put for 2.00 (assigned)
Your cost basis for this position is not $38 (40 - 2). Your cost basis for this position is $29 (40 - 3 - 2 - 4 -2). This is a very important difference. Not only is your position better off than you originally believe because your cost is so low but you will need to know this information to make sure you don't lose money on this entire strategy.
Now that you have been assigned the stock it is time to start shorting calls. You don't need to wait to start shorting calls for the underlying to run up or set up in some way, start shorting calls immediately. For calls you want your strike selection to be 2-3% out-of-the-money. This will allow you to make money on the stock appreciation before you sell off your shares.
You don't want to sell calls if it is going to cause you to take a loss on the total position. This is where you need to keep track of all your premiums received plus the stock appreciation. If getting a call assigned will cause you to take a loss don't do it. This is where you either need to dump the stock and move on or hold it until the setup returns. This is the advantage of trading index ETFs or stocks you want to own. There are times you could get caught holding the underlying for an extended period of time.
If the underlying is in a position where you can sell calls profitably then you need to keep doing it until you get assigned and the shares get called away. Don't adjust the position to heavily to try and capture the dividends offered. If you are trading in and out of the position enough, especially using Monthly Options, you will capture dividends. You may not be able to collect all of the dividends offered throughout the year but you will be able to get some just by sticking with the basic strategy.
The Wheel Trade is a great way to consistently generate income throughout the year. The constant income sources from put sales, dividends, stock appreciation and covered call sales generate returns that can exceed a simple buy and hold strategy. When choosing your short puts it is as simple as going one strike out-of-the-money. Once you are assigned start selling calls 2-3% out-of-the-money until you can get rid of the shares profitably. The most important part of the Wheel Trade is to keep track of all your income from each trade. Without that information you won't be able to tell if you are truly profitable or not.
Which stocks are you looking at using the Wheel Trade on? Tell us in the comments...