Lets discuss an alternative strategy to just buying stock. The wheel strategy is one of my favorite ways to generate income without using as much buying power as just buying 100 shares of a stock. I will compare the wheel strategy to buying stock so you can see if it fits your risk profile, capital requirements, and trading style.
We’ve talked about how to pyramid into a position instead of just buying all the shares at once, but I think the wheel strategy is something you should also consider. The wheel strategy enables traders to buy stocks in a more controlled and strategic way.
Understanding the Wheel Strategy
Instead of immediately buying 100 shares of a stock, the wheel strategy involves selling puts at the delta and expiration of your choice. Dr Eric wrote about put sales last week! By selling these puts, we collect premium immediately, generate income and potentially reduce our cost basis. Depending on the delta of the put you choose you get a cushion in case the stock goes down. If the put expires out of the money you will keep the premium, if the option goes in the money at expiration the premium reduced your cost basis by the amount of premium received.
Comparing the Wheel Strategy to Buying Long Stock
Let's compare the two scenarios of buying 100 shares of a stock versus implementing the wheel strategy. For this comparison, I will use the example of the stock SPY, which is close to $500 a share.
If we were to buy 100 shares of SPY at $500, the cost would be $50,000.
On the other hand, if we were to sell an at-the-money put with a 45-day expiration, the capital requirement would be $10,000.
So, the wheel strategy requires significantly less capital compared to buying long stock.
Understanding Deltas in the Wheel Strategy
Deltas play a key role in the wheel strategy. When buying 100 shares of a stock, each share has a delta of 1.00. This means that for every $1 movement in the stock price, the value of the position changes by $100. On the other hand, when selling an at-the-money put, the delta is around 0.50. This means that for every $1 movement in the stock price, the value of the position changes by $50. Understanding deltas is important for managing directional risk and potential profits in the wheel strategy. If you sell a 0.30 or 0.20 delta put you are decreasing your premium received, but you are also agreeing to buy the underlying at an even lower price.
The Importance of Cost Basis Reduction
Cost basis reduction is a key concept we discuss at GKT. By consistently selling puts and collecting premium income, traders lower their cost basis over time. Cost basis reduction is similar to buying a house and renting it out. The rental income reduces the overall cost of the house, providing a financial advantage. Similarly, in the wheel strategy, selling puts reduces the cost basis of the stock position.
If the stock continues to drop and you are assigned shares of the stock that you were going to buy anyway, you can start selling covered calls against your shares to get called away at a higher price! Of course, this depends on your trading style and assumes you do not mind capping your upside. Selling the call also generates more income, which is one of my primary focuses for my active trading account.
The reason it’s referred to as a wheel strategy is you continue to sell calls until you get called away, then you can go back to selling puts again. The cycle continues where you sell puts, until you get shares, then you sell calls until you are called away, then you keep this cycle going over and over.
The wheel strategy offers several benefits over buying long stock.
1. it requires less capital, making it accessible to a wider range of traders.
2. it provides a cushion in case the stock goes down, potentially reducing losses.
3. it allows for cost basis reduction, which can lead to increased profitability over time.
However, it's important to note that the wheel strategy also has some risks. If you do not own any shares you are missing out on appreciation of owning shares. If the stock price goes up significantly, traders miss out on potential profits. Additionally, if the stock price keeps going down, the wheel strategy requires active management and adjustments to avoid losses, but that is the same as owning shares.
Implementing the Wheel Strategy
To implement the wheel strategy, traders should follow these steps:
Sell a put to collect premium income and reduce the cost basis.
If the stock goes down and the put gets assigned, sell a call against the stock position.
If the stock goes up and your shares get called away repeat the process by selling another put.
Manage the position by rolling the puts and calls as necessary to maintain a profitable and protected position.
The wheel strategy offers an alternative approach to buying long stock. By selling at-the-money puts, traders can reduce their cost basis, lower capital requirements, and potentially profit even if the stock price declines. While the wheel strategy requires active management and adjustments, it can be a powerful tool for traders looking to optimize their trading strategies. So, next time you consider buying stock, consider giving the wheel strategy a try!
I hope you enjoyed this post and learned something new. If you did, please share it with your friends. And if you want to learn more about trading strategies and how to apply them in different market conditions, join our discord! Subscribe for our weekly newsletter. It's all free!
Happy Trading Good Kids!
Disclaimer: this is NOT financial advice. I’m basically just some dude on the internet who’s been trading a while, and I use the stock market as my primary source of income. None of this is financial advice it’s purely educational!
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