The Wheel Option Strategy.
I have chosen the image above as it illustrates the absurdity of not using something in the way it was designed to be used. The stock market is not an income-generating machine, although many people think that they can use it in that way. It may work for them for a time – but you don’t get something for nothing. You have to pay the piper at some stage.
Dividends, Schmividends
We covered dividends a couple of weeks ago, and saw that you would need over $7 million to get a $100k annual income. Not so here in Australia; people here are addicted to dividends, and almost all financial advisers recommend high-dividend stocks. Compared to the U.S. Australian dividends are generally high, over 3 times higher than the S&P 500 and over 5 times higher than the Nasdaq 100. People need a lot smaller capital to get a $100k income.
What’s the downside?
I think the following graph says it all:
Now, correlation does not always mean causation – but my analysis is that there is most definitely a causation here. Instead of using profits to invest in their company’s growth they chose to give them to shareholders instead. Look at the differences in the capital increase of the stock.
Sure, investors got ongoing dividends – but a 26% increase in capital over almost 20 years? Not what I think is acceptable, hence I trade very little in Australia.
(An aside – strangely, the big superannuation funds who own the majority of stocks on the ASX say they are averaging almost 8% a year. I would like to know how this can possibly be true!!)
But onto the Wheel Strategy
The wheel strategy has been around since the 1990s and is touted as a beginner-friendly income generating way to trade. It reached new heights of popularity during the covid pandemic when many people at home started trading for the first time. This is how it works:
- Sell Cash-Secured Puts:
Sell a put option at a strike price where you’re willing to buy the stock. You must have enough cash to purchase 100 shares of the stock at the strike price if assigned. If the option expires worthless, you keep the premium and can repeat the process.
- Buy the Stock (if Assigned):
If the put option is exercised, you purchase the stock at the strike price, which may be below the current market price, reducing your effective cost basis.
- Sell Covered Calls:
Once you own the stock, sell a call option at a strike price where you’re willing to sell the stock. If the option expires worthless, you keep the premium and continue to hold the stock.
If the option is exercised, you sell the stock at the strike price, realizing a profit plus the premium collected.
- Repeat the Cycle:
After selling the stock via the covered call, return to selling cash-secured puts to restart the cycle.
Problems with the Wheel Strategy
Firstly, you are stock-picking, and studies show that stock pickers practically never beat the market.
Secondly, you are an active trader, and studies show that they also underperform the market in the vast majority of cases.
Thirdly, you are owning the stock, and so are exposed to significant downside risk if the stock drops sharply (which they do, frequently)
Fourthly, you are capping your upside through covered calls (which we have looked at in a previous blog). For example, if the stock is trading at $50, you sell a call at $52, then it surges to $60 you are missing out on the extra $8 per share.
Fifthly, it doesn’t work well at all in a low-volatility market, where premiums are low making it harder to get a decent income as we have seen.
The Wheel is risky
The Wheel (in my opinion, and, yes, I know I am opinionated!) is risky and to me the rewards don’t justify the risks.
Yes, all trading has risks, but there are ways – like ITM – to minimize these risks. The Wheel exposes you to risks on the downside and limits your rewards on the upside.
We can be brilliant traders in hindsight
Of course, it is easy in hindsight to select a few cases where it worked (and then, of course, claim to be an expert and write a book about it!), but I have yet to see it work consistently over time.
What the stock market is – and isn’t
The market is not an income-generating machine; it’s a vehicle for capital growth, not a predictable cash flow.
I have little patience with the whole idea of income-generating techniques. That’s not what the stock market is for. Like the early cars when people just didn’t get what they were about.
In an effort to make the less dangerous, there was the ‘Red Flag Act’ in the UK, which mandated that a man with a red flag had to walk in front of an automobile (which wasn’t too restrictive as the speed limits were often as low as 2 – 5 mph). Here is Charles Rolls in his automobile, with the flag-man in front.
Horse-drawn automobiles were used for US mail delivery.
What has this to do with the stock market?
Why the comparison with early automobiles? Because people didn’t get what they were about. Just like they don’t get what the stock market is about. If you want a weekly or monthly paycheck, you have to get a job. The stock market will not give you a reliable income. That’s not how it works.
Wealth Generation
As a wealth-generating vehicle, the stock market is wonderful. It’s the only way of making most of us wealthy (legally).
Speaking for myself, if I hadn’t discovered how to make money on the market, I would have a very dismal life indeed!
An interesting aside
When I was researching early automobiles, I went down the rabbit hole after Charlet Rolls, (of Rolls Royce). Strangely, he died in 1910, aged 32, in a crash. Not an automobile accident, but a plane crash.
He was the second Briton to go up in an airplane (1908, piloted by Wilbur Wright) and was the second person they licensed to fly a plane. He made 200 flights, including a non-stop double crossing of the English Channel which took 95 minutes. On his last flight, the tail of his plane broke off when flying at 80 feet, and he became the first Briton to lose their life in a plane crash.
To the markets
It was a shortened trading week last week, with Wednesday being the last full day of trading – and the market dropped. Friday was a short day, and the market rebounded – nice. A good way to end the week.
SPY Charts
SPY has closed over 600 for the first time! There were ticker tape parades and traders were celebrating, dancing in the street.
You missed it? So did I.
It was barely mentioned in the press, but I think it a very positive sign. Looking at the chart we can see that it proved resistance in early November, but now has closed over it twice.
On past behavior we would expect that it will increase for a while then traders will get cold feet, and it will retrace to test support at that level.
Or not. The market does what the market does, we can only watch and make an educated guess.
Let’s remind ourselves of what happened earlier this year when it broke through the 500 barrier. You can see that it didn’t hesitate but went straight through, then got a fright at its own audacity and retraced to test 500 for support.
On the weekly chart we see that it is towards the higher end of its trading channel.
SPYG Charts
SPYG has not yet made a new high (it is below the high of early November) but it is still a nice-looking chart with support established at the $85 level.
On the long term chart, it is still in the middle of its trading channel.
QQQ Charts
Like SPYG, QQQ has not yet taken out the high it made in early November, but is still a nice-looking chart.
The long term chart shows that it is still crawling up the bottom of its trading channel.
VIX Chart (Volatility)
The VIX chart shows that we are back in low-volatility territory.
ITMeter
The week ahead
There are no major dramas this week that I can see. The market will be fretting about the “Trump Tariffs’ and the Fed meeting on 17 – 18 December, but there is one interesting – and positive – sign.
Managed Funds and ETFs have been experiencing significant capital inflows since the election.
In the week ending November 27, US equity funds attracted $12.78 billion, and it was the fourth consecutive week of net inflows.
There has also been a big increase in investor money flowing into ETFs.
Clearly, investor optimism is growing about the economic policies of the new administration, and this is likely to push the market higher. The inflow of capital means that fund managers have to buy, and this increased demand can drive prices higher.
Historically, there is a correlation between inflows and a rising market. However, this does not mean that the rise will be without some setbacks.
Traders are very keen to ‘lock in their profits’ and sell before they can get taken away in a downturn, and fear is a stronger emotion than greed.
There will be some sudden drops over the next month or two, but I am not expecting them to be significant.
The futures
And the futures give an example of what I am talking about. They are currently negative, not a lot but show that some nervous nellies (is that an expression in the US?) are selling at what they think is a market high. We’ll see.
I have often noted that in the first half hour of trading the market drops, then around 10AM it starts to reverse. Not all the time, but quite often. Let’s hope that is what is going to happen today.
Fingers crossed for a good week!
Heather
Q & A
Please ask any questions here, or feel free to leave a comment.
(I need to work out how to get that ‘leave a reply’ off the element)
25 Responses
There is an active online community in high yield investing and it is not “junk bond”.
Instead there has been a great deal of innovation in covered call strategy ETFs.
There are books on the subject. Many YouTube channels (choose them carefully and make your own decisions)
There are other high yielding assets classes besides covered call ETFs like BDCs, CLOs, and various closed end funds.
Diversification is always important.
I know about the Wheel Strategy, but would never want to rely upon it as my primary income source when I retire.
Hi Ed – thanks for info about the high yield investing – maybe you could share it with other traders in ITM Chat?
I must say I am curious about the inovation in ETF covered calls – is there something I am missing?
h
Hi Heather,
1. After just reading you book entitled, “Timing the Market”‘ I wonder where on your blog do I find an alert if a ITM signal is coming up? I visit your blog frequently but I am not sure where to look for an alert.
2. I have read in addition to “Timing The Market,” Iv’e bought and read ITM Bear Market annd ITM Bull Market. Very helpful and I’ve made good money on DITM!
Thanks,
John 12/6/24
HI John,
the alerts is in the ITMeter, and it has been pointing to a bull since November last year. I am not a financial adviser so I can’t advise people what to buy, just highlight what I am doing so thet people can follow if they wish.
There are very few alerts – we tend to stay in trades while the bull is running, and there are really only alerts when we see a golden or death cross.
Glad you are making money – I am just updating my wealth spreadsheet and am very happy also!
h
How much over the 1% of the effective price can I go and be safe? If I can’t find a suitable SPY option at about 1 year away, what should be the closest SPY option should I purchase? Thank you in advance for your answers to these questions.
Richard
Hi Richard – in the latest editions I have adjusted the parameters because of the increase in interest rates sine I wrote the books.
I am using 6-9 expiry, and 1% time value on 50% strike and 2% on 60%.
Looking at todays options chains, if we choose a June 2025 expiry date then the 50% strike ($300) has a ti,e value of 0.99% and the 60% ($365) is 1.32%. Both of these fit withint the parameters – which are only a guide, you are never (ok, practically never) going to get anything exactly on 1% and 2%.
Hope this helps.
h
Dear Heather,
Thank you for your weekly blogs as always. With the ITM Method, we can get annual return of 15% and double our money every four years. This has been supported by your backtesting of the ITM performance since 1993 using SPY. It is simple and does not require much time. We need to keep the ITM as simple as possible. Don’t make it complicated.
Sincerely,
George Halongton
Hi George,
nice to hear from you.
The problem with ITM and the market is that it is ‘lumpy’ – it is not the linear increase that you get by putting your money into the bank and seeing it grow every day.
Instead we have bad periods – like just after publishing ITM I had to deal with the Biden Bear and all the associated abuse! Terrible timing – but you can’t predict only make the strategy cope with ups and downs in the long term. Which ITM does.
And while I have accounts that do solely ITM (and they are doing very well, like everyone else doing ITM), I have other accounts where I try different strategies – all based on SPY & QQQ – so we are just talking about the mix and basic math here. They are doing very well – one is up 1-Year Change (+92.95%) and the other 1-Year Change (+379.75%) These are both cut and pasted from the Schwab accounts. The actual $ figures removed for obvious reasons. But happy to provide snapshots for the unbelievers!
However, I am not going to write about these strategies or publish them as I can’t be bothered dealing with the online abuse and blackening of my name by unsuccessful traders. That rankles, and you don’t have the right of reply.
I would prefer to totally enjoy the freedom that the money gives me, and still feel that I am dong my bit by publishing the ITM books and answering questions to try to help people with that strategy.
Hope this makes sense.
h
Dear Heather,
Thank you for your response.
I appreciate it very much.
Sincerely,
George Henry
Hi Helen, I agree with you that the wheel is an underperforming strategy, but for people who have ETF shares like spy or smh, making covered calls that are way otm (for say 45 days DTE, .1 delta) it might add a little bit in terms of total returns, which helps, say 2 or 3% additional income. I of course prefer to use your strategy instead.
Hi Pedro – I get what you are saying – I also have SPY and QQQ shares as the unleveraged part of my portfolio, and I have often looked at selling covered calls but have never been tempted as the returns are so small unless you come very close to the current price, and then the risk is that you miss out on the good days – like last night on QQQ!
Bit ITM is only a suggestion – I am not telling people what to do just showing them how to do it! If it is working for you then go for it.
h
Helen, I would like to express my gratitude for your providing a choice/partition for expressing your political views separated from your options trading knowledge. It allows me to get what I need (options wisdom) undistracted. Thanks again.
Robin
Hey Robin,
I don’t think I have ever been in such a political situation where feelings run so high and people get so easily offended!
I try to avoid politics as much as I can, but it DOES have an effect on the market, so it is sometimes unavoidable.
But I try to keep it to a minimum.
However, that doesn’t stop people discussing it in the blog.
h
Hi Heather,
At what percentage point should one consider rolling up or out your DITM option?
Regards
Hi – making a habit of rolling out at 30 days before expiry is good. Rolling up? I would suggest that if you are doing the 50% strike then roll up when you get to 40% and if using the 60% strike then when you get to 50%.
It doesn’t have to be exact – these are riles of thimb.
Hope this helps
h
I’m typically a Nervous Nellie whence I wet the bed and attract Looky Lou’s… A Looky Lou can be seen almost anytime in traffic riding by a car crash…to slow down and see what’s going on which in turn makes the traffic jam even longer.
Stock Market – buy low and sell high if it doesn’t go up – don’t buy it…
R
Randy – short but sweet! Yes, why would you buy a stock that wasn’t going up??
h
Hi Heather,
I have been doing wheel strategy from last one year and made 20k gain until now.
and on capital of 100k
Would you mind going through my excel sheet and point out if I am missing anything
Hi Kishore
well done, glad it is working for you.
Just pointing out – we have been in a bull market, and SPY has gone up more than 20% and with a lot less risk than using the Wheel.
But if it works for you and you are happy doing that amount of trading then go for it – just be careful of the downsides.
Happy to look at your spreadsheet – send it to info@heathercullen.com and use the subject: ITM BLOG – The Wheel Strategy, then I wont miss it.
h
Done
Hi Kishore
well done, glad it is working for you.
Just pointing out – we have been in a bull market, and SPY has gone up more than 20% and with a lot less risk than using the Wheel.
But if it works for you and you are happy doing that amount of trading then go for it – just be careful of the downsides.
Happy to look at your spreadsheet – send it to info@heathercullen.com and use the subject: ITM BLOG – The Wheel Strategy, then I wont miss it.
h
Hi Heather,
The expression”nervous nellies” is known to citizens of the USA, usually older citizens like me.
Do you recommend using the DITM Strategy with QQQ? Thanks,
John 12/2/24
Hi John
thanks for info!
Re ITM on QQQ – I use it, have for some time, and the results are good.
I didn’t put it in the books because I wanted to keep things simple and easy.
Hope this helps
h
Yes, “nervous Nellie” is a U.S. expression too, but with the “N” in “Nellie” usually capitalized.
A “high strung” young horse that stayed that way would be a “nervous Nellie” old horse. For some reason, the name Nellie became associated with horses as in “Woah Nellie.”
Hi Jay – thank you!
Actually, now I think of it it is a Scottish expression (my childhood was in Scotland, not that you’d guess with the name Heather!).
In Australia we are rather more vulgar – we call them ‘bed wetters’.
I didn’t want to use that in the blog in case I offended anyone!
h