The Options Wheel
‘The Wheel’ is probably the highest profile of all options strategies right now. It is a cyclical process where you:
- Sell put options on a stock / index that you would like to buy, typically 30 – 45 days to expiration. If it expires worthless you don’t buy the stock, but you get to keep the premium. You keep doing this until you are exercised when you:
- Buy the stock. You are now the proud owner of the stock at the strike price of your options. You then proceed to:
- Sell covered calls against the stock you have just bought, getting a premium. If you are exercised, then you:
- Go back to 1 and do it all again.
All very clear – but does it make a profit? It seems so – this guy claims he makes $31k a WEEK!
Using the Wheel on SPY
Let’s check it against SPY. Today is the 22nd of January so let’s look at 23rd February puts. SPY is trading at $482.43 (Woohoo! A new high!) so let’s say we would like to buy it at a 3% discount, or $468. The bid / ask is 1.73 / 1.75, so that gets us $174 premium. Nice – but what is our obligation?
If we are exercised then we are able to buy 100 shares of SPY at $468, so we need to come up with $46,800. You need to check – will your broker allow you to sell puts? You have to have a high level of access to be able to do this.
You could do a cash-secured put, but that requires you to actually have enough cash in your account to buy the stock if it is exercised. If you look closely at the video above you will notice this:
The Wheel Returns
Let’s assume that we are committed to the Wheel and that we have deposited $46,800 in our account. Our premium for the month has netted us $174, or 0.37% for the month. Of course, we can do this every month which would give us a yearly return of 4.46%. I don’t know about you – but my feeling is why bother? You are taking a lot of risk for less than you would get on a fixed term deposit.
The Wheel Risks
Now, to be exercised SPY has dropped to $468 (which it must have otherwise you would not be being exercised) so you are now the proud owner of 100 SPY shares. Is it a bargain? Well, you know that SPY is trading at less than that otherwise you wouldn’t be getting exercised. You could buy on market for the same price or less. But what if it had dropped even further?
Suppose it had dropped 5% (which it can easily do in a month) to $458. This means that you are having to buy something costing $46,800 when it is actually only worth $45,800. In other words you are down $1,000 on the deal. You still have the $174 premium of course, so you have only lost $826, or 2.7%. But you certainly don’t want to be doing that every month as that is a 34% annualized loss.
The Wheel In Motion
But we press on. We’ve bought our SPY shares – now we have to sell covered calls against them. Let’s look at the premiums we can get at current prices. If we look at 5% above the current price – we have a bid / ask of $45 / .45 so we would get a premium of $44, or 0.09%. Cheer up, when annualized that is 1.08%, a princely return!
Naturally we only win if SPY doesn’t go up more than 5%. Could it? I think so, it has done so frequently before.
Suppose it went up 10% – you will be forced to sell it at a 5% discount to the market. A loss of $2,412 of actual profit.
That would hurt. Quite a bit.
Conversely, if SPY was starting a strong upward run you might never be exercised, so you would never get on it. Sure, you get to keep the premiums, but they are a poor substitute for owning the underlying in a strongly trending market.
Is the Wheel A Good Strategy?
In my opinion, no. I have never seen is as a profitable strategy and I have looked many times. I’ve checked various strikes, expiries and stocks but to me the payback is never worth the risk.
Of course, the books all show great examples of it working wonderfully. All I am going to say is:
We can all be brilliant traders in hindsight!
I have just finalized Mark I of my backtesting system, and am in the process of updating the Bull Strategy to the end of 2023. I will give a heads up here when it is published. I am not doing it as a formal new edition which means that anyone with an eBook can get the update free. I think, that is the policy. However, it is down to Amazon to put it into practice, I have absolutely no influence over that.
I will also update ITMB, the bear market book. That should be quicker. And curiously – the bear book has been outselling the bull book in January . . do people know something I don’t?
To the markets . . .
And a nice end to the week, with new highs. Very happy, that’s a good sign. We deserve some lovely profits after the last 2 dismal years. Let’s have a look.
The big news about SPY is that it has made a new all-time high! Yes, it closed at $482.43 on Friday, above the previous all-time high of $479 from January 2022. So, good news at last! Of course, once we are in ‘blue sky’ territory we are flying blind, but we can make a guess that the next resistance is going to be at 500. Why? Just because it is a nice round number and I imagine there will be a psychological barrier at that level.
Naturally, I could be wrong. I expected it to falter at 400 in March 2021 and it didn’t; it just sailed right through without a backward glance. It would be nice if I am wrong again, and we are seeing the start of a lovely bull market.
It is possible that SPY will retrace to the support / resistance line around $479. This would be entirely normal behavior, and as long as it holds is nothing to worry about.
For some perspective, here’s the last 3 years showing us breaking through resistance at the previous all-time high.
SPYG retraced to test resistance as we discussed in last week’s blog. It bounced off again and headed north, making a new post-bear market high.
However, it is not making new all-time highs; it still has a way to go to surpass the December 2021 high as you can see in this chart:
QQQ is also in ‘blue sky’ territory. It has surpassed its previous all-time high of $403.78 in November 2021. It spent a couple of weeks above it in December, then retraced at the start of the new year falling below it for a week or so. It is now above it again and has been for almost 2 weeks, which is very encouraging.
The longer term chart shows the breakthrough, then retracement then back for another shot at breaking through.
The VIX continues in low-volatility territory, which is nice. In December and January it has been the lowest since huge spike during the Covid bear
The week ahead . .
Well, we got our wish from last week – that SPY made a new high. So, flushed with success I’m going to make another one – more all-time highs please!
At this stage the futures are positive – 12 hours before market open.
Fingers crossed for another good week – we surely deserve it after the last 2 dismal years!