What is the Wheel Strategy and How Does it Work?

Investors always look for effective trading strategies that can help them maximize returns while managing risks. Among the plethora of trading techniques available, the wheel strategy offers a unique approach to trading. Although the strategy is often associated with options stock trading, the structured and systematic method of generating consistent income makes it attractive to cryptocurrency traders.

If traders can understand the fundamental principles of the wheel strategy and master its implementation, they can find new opportunities for wealth creation and portfolio growth.

Understanding the Basics of the Wheel Strategy

Bear in mind that the wheel strategy was first created for options trading. Many investors may view options trading as complex, but the wheel strategy simplifies the process. What are the core concepts of this strategy?

Definition and Concept

The wheel strategy, also known as the ‘’triple income strategy’ is a technique that involves selling cash-secured puts and covered calls on a stock. The wheel strategy seeks to generate income by collecting premiums from selling options while aiming to buy or sell the underlying stock at favorable prices.

The wheel strategy can be traced back to the concept of covered calls used in options trading for decades. Over time, traders refined this approach and incorporated additional elements, such as selling cash-secured puts to generate income.

What Are Puts and Calls?

Puts

A put option gives a trader the right to sell an asset at the strike price on or before the expiration date. Put options are usually used to hedge against downside risk or to speculate on a decline in the price of an asset.

If the price of an underlying asset falls below the strike price, the put option becomes valuable, and the trader can sell the asset at a higher price.

Calls

A call option gives a trader the right to buy an asset at the strike price on or before the expiration date. Call options are commonly used to speculate on an increase in the price of an asset.

If the price of an asset rises above the strike price, the call option becomes valuable, and the trader can buy the asset at a lower price.

Key Components of the Wheel Strategy

Selling Cash-Secured Puts

This involves selling put options on a stock or cryptocurrency you would not mind owning at a predetermined price. This predetermined price is called the strike price. Doing this allows you to collect premiums upfront, generating immediate stock income.

You promise to buy the shares at the strike price when you sell a put option. In exchange, you receive a premium or dividend as your obligation to purchase the shares.

Covered Calls

Once you are assigned the stock by selling puts, you can sell covered calls against those shares. This involves selling call options on the stock you own. You can earn additional premiums while capping potential gains if the stock rises above the call’s strike price. In essence, you profit upon the expiration of the strike price.

The strategy hinges on the idea of buying low and selling high. You receive stock at a discount (cash-secured puts) and sell above the market price (covered calls). The asset you apply this strategy on should be in a bullish or sideways trend.

Strike Price

The most significant component of the wheel strategy is the strike price. The strike price, also called the exercise price, is the predetermined price at which you can buy or sell the asset if you exercise the option.

For call options, the strike price is the price at which the holder must buy the underlying asset. For put options, the strike price is the price at which the holder must sell the underlying asset.

The strike price is specified when the options contract is created and remains fixed throughout the duration of the contract or till expiry.

How Does the Wheel Strategy Work?

The wheel strategy combines selling cash-secured puts and covered calls to generate income and potentially acquire or sell the underlying stock or crypto asset at a favorable price. For each option contract sold, you should be prepared and have the funds available to purchase 100 units or shares of the stock at the agreed strike price. This ensures you can fulfill your obligation if the buyer exercises the option.

The steps below outline how the wheel strategy works using ETH as an example. In these examples, the prices and premiums are hypothetical.

Step 1: Selling Cash-Secured Puts

Suppose you are interested in acquiring ETH, trading at $4,000 per token at the time of the transaction. You decided to sell a cash-secured put with a strike price of $3,500 with a 30-day expiration.

The premium you receive from selling each put option is pegged at $200 per token. In most cryptocurrency exchanges that offer options trading, the premium you receive is quoted in the market as you place your order. There are two possible scenarios:

Scenario 1: ETH Price Remains Above $3,500

If the ETH price remains above $3,500 by the expiration date, after 30 days, the put option expires worthless, and you get to keep the premium ($200 per token).

You can then repeat the process by selling new cash-secured puts to generate additional income.

Scenario 2: ETH Price Falls Below $3,500

If the token’s price falls below $3,500 by expiration, you will be assigned to buy 100 units of ETH at the strike price of $3,500 per token. However, remember you sold cash-secured puts and collected premiums/profits. Therefore, you are prepared to purchase the token at $3,500, using the cash you set aside as collateral. Your purchase price is reduced by the premium you receive, mitigating the downside risk.

Selling cash-secured puts is better suited for sideways or bullish market trends. If you are neutral or bullish on an asset, selling cash-secured puts might be your best option. Otherwise, if the asset is heavily bearish, you must buy the asset at the strike price upon expiry while waiting for the asset’s price to recover.

Step 2: Writing Covered Calls

You use covered calls after you have been assigned an underlying asset through the assignment of a put option. This may happen if scenario 2 from selling cash-secured puts occurs when you get assigned to buy a cryptocurrency. In this case, suppose you are assigned several units of ETH at $3,500 per token. You decide to write covered calls with a strike price of $4,000 with a 30-day expiration date, and the premium or profit you receive for selling each call option is $300. There are two possible scenarios;

Scenario 1: ETH Price Remains Below $4,000

If the ETH price remains below $4,000 by the expiration date, the call options expire worthless, and you keep the premium collected ($300 per option). You can then repeat the process by writing new covered calls to generate additional income.

Scenario 2: ETH Price Rises Above $4,000

If ETH rises above $4,000 upon expiration, your asset is called away at the strike price of $4,000 per token. However, since you sold covered calls, you are prepared to sell the tokens at $4,000, which was your target selling price.

Your selling price for ETH is increased by the premium you receive, increasing your overall returns.

In this scenario, you are banking on ETH to remain neutral. However, note that if the asset’s price rises significantly, you must sell it when it is called away at the strike price.

Step 3: Repeating the Process

Once you have sold the cryptocurrency or stock at the predetermined price, you can start the process again by selling cash-secured puts or covered calls. You may repeat using the wheel strategy on the same asset or another’s.

Repeating these steps can help traders generate income from selling options premiums while potentially acquiring or disposing of the underlying asset at favorable prices, thereby implementing the wheel strategy.

Factors To Consider When Using the Wheel Strategy

When using the wheel strategy, it is essential to consider factors that can influence your trading approach while effectively mitigating your risks. Key factors include risk management, market conditions, stock selection, and strike prices.

Capital Requirements and Risk Management

An essential aspect of the wheel strategy is understanding the capital requirements and risks involved in each process stage. Selling cash-secured puts requires maintaining sufficient cash reserves (or deposits) to purchase the underlying stock if it is assigned.

Writing covered calls involves owning the underlying stock. Although this protects the downside, it limits potential gains if the stock price increases significantly.

Market Conditions

Assess current market trends, volatility levels, and macroeconomic factors that may impact the performance of an underlying stock. You may also need to adapt your trading strategy to thrive in different market conditions, whether bullish, bearish, or sideways.

Stock Selection

To find suitable stocks for implementing the wheel strategy, you should conduct a thorough fundamental and technical analysis to identify them. Look for stocks with strong fundamentals, stable price trends, and sufficient liquidity. This will help you build confidence in the stock if you need to hold a stock for an extended period.

Appropriate Strike Prices

How profitable this strategy will turn out for you will depend on how well you choose strike prices. You aim to strike a balance between generating income and managing risk. Higher strike prices offer higher premiums but also pose a greater risk. Lower strike prices provide more downside protection but also lower premiums. Your strike prices may depend on market outlook, expiration date, volatility levels, and income goals.

Conclusion

The wheel strategy combines elements of options trading, aiming to capitalize on market movements while managing risks. However, success with the wheel strategy depends on thoroughly understanding its core concepts and considering factors such as applying proper strike prices and selecting stable assets.

The strategy can be applied to traditional stocks and cryptocurrency markets. Using this strategy can open the door to capitalizing on long-term financial success.