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Options trading can be a means to make a lot of profit quickly, but if done incorrectly, it can haunt your portfolio. Trading options are beneficial only when the right option strategies are applied. The Options Wheel strategy is one of the best income-producing option trading strategies as it enables investors to get paid for buying the stocks they genuinely love.
This enhanced version of the Buy and Hold trading strategy is one of a kind, as it allows investors to profit from their desired stock in four ways. Besides, although the stock market and options trading involves huge risk in high volatility markets, the Options Wheel Strategy still comes with a relatively lesser risk exposure while offering higher profitability potential simultaneously. Therefore, it has become trendy among traders who intend to generate income before or while holding a stock. There are several option signals services available if you are interested in following full-time traders.
What is the Options Wheel Strategy?
An Options Wheel Strategy involves selling put options, owning stocks, and selling covered calls until the shares are called away or the position is closed. The goal is to consistently take in credit via selling short put options. Without further delay, let’s jump into the steps in an Options Wheel strategy:
Step 1: Choose a Stock
Step 2: Selling a Secured Put Option
Step 3: Selling a Covered Call Option
Step 4: Repeat the steps mentioned above as required
By further digging in, this strategy can be framed easily by two major components: Selling a cash-secured put option and selling covered calls of the assigned stock. Also, investors can go back to step 1 to restart the “wheel” on the same or a different stock as per their choice.
Detailed Steps for constructing an Options Wheel Strategy
To construct an Options Wheel Strategy, the investors must understand each step involved.
Step 1: Choosing a stock
This is by far the essential step of this trading process, as the success of this strategy is determined by this step. To begin with, anyone who wants to use this strategy should always go for high-quality stocks with strong fundamentals and long-term upside potential. This is because fundamentally strong stocks rise again after a fall, allowing value investors to buy in the dip. Moreover, this also reduces the possibility of a steep decline in the value of a stock after purchasing it through a Put Option. If anyone feels holding stocks for the long term can be an issue, they can select dividend aristocrat stocks, as holding these stocks for the long term will provide them additional benefits.
Step 2: Selling a Secured Put
After picking up one’s desired stocks which they would like to buy and hold on to for the long term, investors will have to sell a Put option on the same stock. This method effectively delays the alignment while the option premium is being collected, and as the stock price recovers, the Premium amount amplifies the profits. Therefore, it is the first source of income.
The short Put can be sold off at any strike price or Exercise price. This means one can get paid for initiating a long position on an underlying stock at a price they would like to buy the shares. The process can be repeated for as long as the investor wants to, and the strike can be adjusted up or down, considering the changes happening in the market.
For instance, an investor wants to buy 100 ABC ltd. stock that is trading at $100 per share. For that purchase, he needs to accumulate $10,000 and sell off a 30-day put option with a strike price of $95. He gets $3/share as a premium from the buyer, with this, an obligation to buy 100 ABC ltd. Shares at $94 are created if the buyer exercises the option. Now, on maturity, after the options have reached their expiration date, the buyer will only exercise the options if the current stock price increases to $96. The investor retains $ 10,000 in his account, along with a profit of $300. After some time, if the option gets exercised while the strike price is $94 and the premium is $2 per share, the cost per share will get reduced to $89. [94-3-2]
Step 3: Selling a Covered Call
Investors can initiate a covered call once they have been assigned the stock. If the buyer exercises the option, as a covered call seller, the investor shall be obligated to sell the shares of stock they own at a predetermined price and generate income. This is, therefore, the second source of income.
For example, a stock is trading at $94, and the investor decides to sell a 30-day covered call having a strike price of $97 for a premium of $2. At maturity, the buyer will only exercise the option if the stock trades at $96. In that case, the investors’ income comes down to $200, and including the above call premium, the overall cost gets reduced to $87.
One can keep selling covered calls till they sell off their shares and continue earning premium income.
Other Income sources
Apart from the first and second sources of income, the two more ways to make money are using Option Wheeling, i.e., dividends and capital appreciation. For instance, instead of selling a call immediately, one can hold on to a stock if they feel it is showing significantly bullish signals. Say the investor expected the stock to increase to $105, which reaches $103, then instead of selling it directly, he can sell a covered call option at $105 and earn $1 as a premium. Additionally, he will get $11 (105-94) as capital appreciation.
To sum it up, the Options Wheel Strategy is ideal when one is bullish on a stock. It enhances the returns and reduces the risk levels as well. The more the options are unexercised, the more premium is earned while the overall cost of the shares reduces, thus providing more capital appreciation. However, an options contract comes with some inherent risks. Even with the Options Wheel Strategy, some risks remain, although losses are hedged to some extent. For instance, if a put is exercised in the first go and the stock price keeps falling even after the investor has purchased the stock, he can either hold the stock or buy a put option at a price below which the losses escalate. However, income from premiums will also reduce as the losses get neutralized.
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