Basic strategy
To keep it simple, I will just deal with 'at the money' (ATM) options here. The basic strategy then is:- Sell a cash-secured put to start
- If the stock goes up, the put expires so you sell another put
- If the stock goes down, the put is exercised, you're assigned the shares, so you can sell a covered call
- If the stock goes down from there, the call expires so you sell another call
- If the stock goes up from there, the call is exercised, you sell the shares, so you sell another put
- repeat...
You can see that when you are assigned shares, you just sell a call, and when a call is exercised, you just use the cash to sell a put. This repeats indefinitely. Isn't this just free money? Sort of...what you're trading off here is a bit hard to see immediately. This is where playing with some numbers can make it easier to understand what's happening.
Simple examples
To get a better idea of how this works, let's look at 3 simple examples:
- stock doesn't change much
- stock drops ~15% in a year
- stock gains ~15% in a year
- stock crashes ~15% and rebounds in a year
In each scenario, I'll add a bit of noise and assume that selling a put yields $1.25/month, selling a call yields $1/month, and these are all monthly expirations and ATM strikes with a starting value of $100.
Imagine in the first one the price for the first 5 months is 100, 102, 101, 97, 101. What does the wheel strategy look like?
- sell put for $1.25 with a $100 strike; gain $1.25 from the sell and lose nothing in stock
- price hits $102; that's above the $100 strike so it expires; sell another $1.25 put with a $102 strike and lose nothing in stock
- price hits $101; that's below the $102 strike so pay $102 for the shares and sell a $1 call with a $101 strike
- price hits $97; that's below the $101 strike so it expires; sell another $1 call with a $97 strike
- price hits $101; that's above the $97 strike so sell at $97 and sell another $1.25 put with a $101 strike
Overall, the wheel earned $5.75 from selling options, but lost $4 in the stock (bought at $101 and sold at $97). That stock loss is the most obvious loss here but there's another more subtle one. Look at the first put again. The gain from selling the option was $1.25, but the stock itself gained $2 then. The gain was effectively capped at $1.25. The same is not true for the loss. When the stock fell, the entire loss was absorbed. Capping gains while having to absorb losses is a primary tradeoff here (some other ones are poor tax performance, low-liquidity, and potentially missing dividends).
Now that that's understood, it's helpful to me to see this graphically, so here are sample runs of the examples from above:
The general behavior here is that the wheel smooths out the plots a bit. Increases and decreases aren't quite as big. You can control how smooth it is by changing expiration dates and strike price offsets (e.g., selling calls with a strike price 10% above current price will allow for larger gains but give you less option premium, so the performance looks more like buy and hold). When a stock crashes, you'll probably do a bit better with the wheel. When a stock surges, you'll probably do a bit worse with the wheel.
The above plots are single trials of the simulation. What does it look like if this is run thousands of times?
That's much clearer to me. In down periods, the wheel just minimizes your losses a bit (loss is stock loss, but you gain option premium). In good periods, the wheel caps your gains so you get a flattened distribution (max gain is the option premium).
Summary
Should you use this strategy? There's no perfect answer for that. In an extremely long bull market (like current), it's likely going to underperform. It does give you a bit of protection against drops and can do better in neutral markets. I personally don't like the thought of capping gains while not capping losses so this isn't a favorite of mine (see the fourth image with the crash and rebound to understand why that can be bad), but it's definitely viable if you want to smooth out your returns a bit.
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