Options Selling (aka Theta Gang) The Wheel Strategy

It seems an options selling strategy, called “The Wheel”, has been gaining popularity lately. Let’s take a deep dive into how this strategy works, some examples, and what kind of returns you can expect from running the wheel on your portfolio. You can get a good feel on the Theta Gang Wheel Strategy works by checking out our Theta Gang section on the site.

Outline Of The Strategy

The wheel is a very simple strategy where you collect premium by selling insurance (selling options) on a stock for semi-passive income. You sell options at a strike price you would be comfortable on “buying the dip” and owning the shares at. For the sake of this example, let’s use AAPL ticker which is currently priced at $115. You believe AAPL is currently fair value and maybe you are already long a position of shares, but you decide that if AAPL drops to $110 per share you will buy more. So instead of wanting to buy shares at the $110 price and waiting until it gets there, you can SELL a single PUT option contract at $110 strike price expiring this Friday. You will collect $2.00 for selling 1 options contract which will give you $200 (each contract is worth the value of 100 shares so you multiply contract price by 100, don’t forget). What happens next? You wait. Should AAPL stay above $110 strike price by Friday, you collect $200 CASH MONEY in only 5 days. Your risk for this play was the amount of capital required to purchase shares should the play go against you. Therefore your risk was the $110 strike price from the options contract * 100 shares for a total of $11,000 required to buy and own the shares. Your Return On Risk (R.O.R) was $200 collected vs the $11,000 capital required for a return of 1.82%. Annualized this return would be 95% (wow). Of course, that would be maximum profit if every week your option expired worthless, and also doesn’t factor in the compounding effect of your capital.

What happens if the stock drops too much?

So, continuing from the example above, there are some risks with running the wheel. If the stock price drops significantly in a short time-frame. You are required to buy the shares at the strike price that you SOLD the PUT option contract at. Again using the example from above, if news came out that China was banning Apple phones and the stock price dropped to $100 per share, you would still be required to purchase 100 shares at $110. In this scenario, your max loss would be approximately $800 ($1,000 max loss minus the $200 premium you collected). You would be assigned 100 shares and be holding them with a cost basis of $108. What happens next? To continue the wheel strategy, instead of selling another PUT contract the following week, you would begin to sell covered calls at the $108 strike (your cost basis) and collect premium (CASHHH MONEY) until your shares get called away (meaning they get assigned to the person that bought the contract).

This seems too easy to collect premium each week. What are the risks?

There are some risks associated with running the wheel strategy and you should always be doing it on stocks you feel comfortable to own for the long-term. The biggest risk overall would be if big news such a bankruptcy came out for the company and the stock drops 90% overnight. In this case your whole position would be out the window. Keep in mind if you were owning the shares anyways as a long-term hold you would still be in the same position (royally Fkd). Besides bankruptcy stocks, stocks that are extremely volatile will have much higher risks, but will also provide extremely juicy and enticing premiums to collect. You can use Swaggy’s IV tracker to see how “risky” a stock currently is. For example, using the ticker FSLY we can see IV or Implied Volatility (in short IV is a gauge for expected price swings, either up or down) is currently at 90% whereas for AAPL IV is only at 40%. In our AAPL example, we were earning a 1.8% return weekly, on a stock like FSLY you would be earning 2.5% weekly and 125% annualized!! However, that’s only if everything goes smooth and we never take assignment of a stock. Just looking at the FSLY stock chart we can see it’s pretty normal for the stock to move 5-10% per day while AAPL only moves 1-2%.

Modifying risk by looking at an option’s DELTA

One thing that’s great about the wheel strategy is that you can take on as much or as little risk as you feel necessary. Different tickers and different strike prices will all provide alternative returns on risk that can be anywhere from 0.5% weekly to 10% weekly. You can look at the option contract’s DELTA. A lot can be written about DELTA and what it is exactly, which I won’t get into here, but I like to look at DELTA as the probability that an option will expire IN-THE-MONEY. A value of 0.95 means a high probability it will remain in the money, a value of 0.05 means it is unlikely it will get in the money. Remember, for PUT options this value will be negative, so use the inverse. The higher you go in DELTA, the more premiums you will be able to collect (as there is a higher chance your play will go against you). You will notice for most stocks that strike prices around the current stock price will be very close to 0.5 DELTA, essentially saying there is a 50% chance the stock will go up or down. When I run the wheel, I generally like to sell PUT options at the strike that is approximately 0.25-0.3 DELTA. This gives me enough premium to be happy, without needing to worry about too much risk. My rule of thumb is generally I don’t take on any trade that provides LESS than 1% weekly.

Final Thoughts

The wheel is a great way to collect premium for consistent gains on stocks you wouldn’t mind holding long-term and see growth in. The limitations of this strategy are that you will miss on 50% returns when certain stocks have big run-ups. In our scenario we used with Apple, whether the stock stayed flat and above $110, went up 10% or went up 25% in one week our returns were always the same, $200. The game of stocks is always an opportunity cost. The more risk you take, the more possibility for rewards, more conservative strategies limit your downside, but also limit upside.