The Wheel Strategy: Selling option contracts to earn side income.

Disclaimer: The information in this article is by no means any form of financial advice and is solely based on my personal opinions and views only. Options are highly risky financial products, and you should always seek help from a trained professional or contact your brokerage before engaging in it. You are warned to only trade with money you are willing to lose as trading is an extremely risky activity. Seedly or I will by no means bear any form of responsibility should you lose money engaging in any form of trading-related activities.

If the idea of making an additional stream of income with your investments sounds attractive to you, and you are keen in learning and exploring new possibilities, read on!

In this article, I will be sharing more about the wheel strategy, an investment strategy involving options that can help you to generate passive returns on a weekly or even monthly basis if you use it properly.

However, do note that just like any other investment strategy or most side hustles out there, the wheel strategy does have its own risks that can result in you losing money as well, so do remember to perform your own due diligence should you decide to try it out.

Moreover, options are leveraged financial products and you should only perform them if you have understand how they work thoroughly, otherwise you should always seek advice from a trained professional before engaging in such activities.

To start-off, the wheel strategy is a combination of 2 options strategies namely, the cash-secured put and the covered call.

1. Selling Cash-Secured Puts

The wheel strategy starts off with you selling a put option of the stock of a company of a certain strike price. It is very important to ensure you have sufficient funds in your account to buy 100 shares of the stock at the strike price of the put option contract you are selling. For example, you can start-off by selling a put option for a company stock of a strike price of $100 that expires this week. By doing so, you will immediately receive upfront premium into your account in the form of additional cash. When the option contract expires, there can be 2 outcomes:

(a) The stock price closes above $100 at expiry. If this happens, the option contract expires worthless, and you get to keep the premium earned from selling the put option. This is ideally the most favourable outcome, and you can keep repeating this until outcome (b) happens.

(b) The stock price closes at $100 or below at expiry. When this happens, you will be forced to buy 100 shares of the company stock at $100. However, since you also received premium from selling the option contract, you are essentially paying for the difference of the strike price (i.e., $100) and the premium received per share. Therefore, you are buying 100 shares of the company stock at a discount.

When outcome (b) happens to you, you may decide to sell the 100 shares immediately or proceed to the next step:

2. Selling Covered Calls

At this stage, you should already have in your brokerage account, 100 shares of the company stock bought at $100 but slightly reduced by the premium received. You may then proceed to sell a call option against the shares you own to receive even more premium. For example, you may sell a call option with the $98 strike price of the company stock that expires next week. At expiration of this call option, there can be two outcomes:

(a) The company stock price closes below the option contract with a strike price of $98 at expiry. If this happens, the option contract expires worthless, and you get to keep the premium earned from selling the call option. You can then continuously repeat this until (b) happens.

(b) The company stock price closes equal to or above the option contract with a strike price of $98 at expiry. When this happens, you will be forced to sell 100 shares of the company stock at $98.

You may then rinse and repeat the entire process of selling cash-secured puts and covered calls continuously after getting assigned 100 shares and have them called away to keep collecting premium. The ideal time to use the wheel strategy is in a side-ways or consolidating market.

Risks Involved

One thing you should take note of when performing the wheel strategy is that if you get assigned 100 shares of the company stock but the price keeps crashing, you may end up with huge unrealised losses on the shares you own and selling covered calls against them at strike prices below the price you were assigned may result in you being unable to earn back sufficient funds to cover the unrealised losses through collecting premiums. In some cases, it may a wiser option to cut losses and sell the stocks assigned to you at a loss.

Next, by selling covered calls against stock you essentially own, you are essentially agreeing to sell them away at a lower price should their closing price be above the strike price of the covered call contract sold at expiration. Therefore, you may lose out on sudden rips in stock price and be forced to sell away the shares you own at a lower price, just so you can collect premium from selling covered calls, should you be actively speculating and trading.

Finally, pin-risk is something to take note of and it happens when the buyer of a call or put option exercises their rights so you, as a seller may still be assigned shares for selling put options or be forced to sell away your shares if you sold covered calls prematurely when the stock price closes very close to the strike price of the cash-secured put or covered call you sold even way before expiry.

It is also worthy to take note that even after the market closes at 4am for the US Market (based on Singapore's time zone), stock prices may still fluctuate, and the option contracts you sold may no longer expire worthless.

Conclusion

While the wheel strategy does have its own risks, it can be extremely profitable if used correctly. The traditional investor will only earn only through capital gains/losses and dividends received but the wheel strategy enables you to earn a weekly or even monthly income through collecting premiums from selling options contracts. Some tips on determining optimal strike prices can be using indicators such as 'Bollinger Bands' or referring the 'Delta of the Option Contract'.

Furthermore, a pro-tip to consider is that the more ideal option expiration dates tend to be weekly, monthly or a max of three months out to expiration since they usually enable you to earn the most premium in the shortest amount of time.

Finally, useful terms to research on if you are keen to start trying out the wheel strategy include: 'Wheel Strategy', 'Cash-Secured Put', 'Covered Call', 'Rolling Over Options at Expiry', 'Pin Risk', 'Intrinsic and Extrinsic Value of Options Contracts', 'Time Decay' and 'Implied Volatility'.

There are also numerous educational contents on about the wheel strategy online but do exercise some form of caution before trusting information posted online!

A final pro-tip I would personally recommend is to open a demo-account and try out the wheel strategy on your own for a few weeks or even months to be exposed to the different possible likelihood of outcomes before utilising it with real money, so you are better accustomed to how it works.

If you are still reading up till here, do comment on which stocks you personally do the wheel strategy on, and please feel free to share further tips as well!