This is the next post in a series about trading the Wheel Strategy. To start at the beginning, go to The Wheel Strategy – Introduction.
[Disclaimer: I’m not now, nor have I ever been, a financial advisor. Don’t do what I do just because I do it, I am not responsible for your decisions. Learn and do for yourself, take responsibility for your own decisions.]
Some of the topics we will be addressing are:
What stocks should you pick? What stocks should you avoid? What strike prices should you use? Should you sell weekly or monthly options? What is the biggest risk of trading the Wheel Strategy? When should you not trade the Wheel?
First and formost, you need to pick stocks that have options. Not every stock does.
For most decisions, there are no actual “right or wrong” answers. There’s a lot of preferences, and even the hard and fast rules often have exceptions.
I’ll save the “what stocks should you pick” for last.
Should you sell weekly or monthly options?
That actually is a matter of preference. I often trade weekly, but I have traded 30 to 45 days out. Weekly and 30 – 45 DTE (Days to Expiration) are the most common choices that people make.
If you trade weekly, your premiums (the amount you get for selling the stock) are smaller, but you make more frequent trades, however, you spend more time finding stocks and deciding which options to sell.
If you trade longer durations, you get more premium, but you don’t trade as often but you also spend less time trying to decide which stock’s options to trade.
It really doesn’t matter which way you choose and you can always change it later.
What strike prices should you use?
This is a tricky one, and contrary to what you will encounter in the wild, there is no right answer.
There’s a lot of people who very strongly believe their way is the best (and only) way, but it is not.
If it works for you, that’s what matters.
The choice of many: Delta
Most people will trade on something called Delta, which is one of the Greeks that are used in options trading.
Now the put options have a negative delta and the call options have a positive delta, and whether delta is positive or negative doesn’t matter. If you’re selling a cash secured put, you look at the negative deltas, if you’re selling a covered call, you look at the positive deltas.
Delta is considered as the probability that a stock will be in the money at the time the option expires.
In other words, if your option has a Delta of 30, then there’s a 30% chance that the stock will be in the money and a 70% chance that the stock will be out of the money at the time your option expires. As always, unexpected news (good or bad) can wildly swing stock prices.
Many people choose an out of the money (OTM) Delta of .3 (also refered to as .30, or 30%).
In other words, you look at your list of strike prices (calls or puts) and find the one with a delta that’s closest to .30, and pick that one.
But you could easily choose a Delta of .20 or .05 or whatever floats your boat.
If not Delta, then percentages work
An alternative to Delta is a percentage of the stock’s current price. I usually target around 1%.
So if a stock’s current price is $20, I look for a strike price where the option is around $0.20 or 20 cents ($20 * .01 = .20)
If you’re doing it this way, then you don’t need to pay attention to Delta at all.
What about the other Greeks?
Delta is really the only Greek that people use in the Wheel Strategy. The other Greeks like Theta and Gamma and the rest matter with other option strategies, but are completely optional in wheel options (get it? See what I did there? No? Sigh.)
And if you’re using percentages of price instead, you don’t even need Delta.
Which stocks should you trade and which should you avoid?
Generally you want to stick will large, well-run companies. Save your risky ventures for money you don’t mind losing. I’ve had good returns trading on companies that trusted traders have recommended.
It’s a good idea to keep your Wheel trades on companies that are trading between $20 – $40. Any less than that and you run the risk of trading poorly run companies or companies that are too new to know.
Any more than that and they get very expensive and you need a LOT more money at hand.
Now there have been some good companies that drop to $10, things happen like natural disasters, wars, etc., but those are temporary and a well-run company will recover.
A stock that’s normally $10 however, is probably best to avoid, especially while gaining experience.
I’ve traded well with companies like SOFI, DKNG, TOST, NOK, and whoever else I’m forgetting. Are these still good companies to trade at the time you are reading this? I don’t know. Do your own research. Just because I’m doing okay with them at the time of this writing doesn’t mean you will.
When shouldn’t you trade the Wheel?
During earnings announcements or divend payouts is usually not the best time to trade as the price may be artifically higher than normal. Also, with stocks that have dividends, there’s an ex-dividend date.
The earnings date is the date that the company announces how it did. A favorable report usually increases the price for a bit and bad or neutral news can drop the price for a bit. The days leading up to the announcement can be volatile.
The ex-dividend date is the cut-off for getting paid dividends. If you buy the stock before the ex-dividend date, then you will get paid dividends. If you buy the stock on, or after, the ex-dividend date, then you don’t get paid dividends.
This also matters because someone might exercise their options and call the shares away from you before the ex-dividend date.
So be mindful around those times
What is the biggest risk of the Wheel Strategy?
The biggest risk of the Wheel Strategy is if your chosen stock suddenly drops drastically in price. This means you may end up buying the shares at a much higher cost than the stock is currently worth. Although this can happen during dividend and earnings dates, this is usually considered a different event with larger price swings.
When this happens, you may not be able to sell your covered calls for a profit because you’ll have a loss if the shares sell.
If you’ve chosen your stock wisely, it should be a well-run company that will eventually recover.
You have three options after it happens BUT you have two extra options if you act BEFORE the price drops:
- Hold and wait. There’s nothing wrong with this but you may be tied up for a long time before you can really trade again.
- Sell for a loss. Not ideal, but it’s always an option.
- Sell another put. Sometimes called “Dollar Cost Averaging” basically if you bought the stock at $100 and it’s now only $50, if you sell another cash secured put and buy at $50, then you now have 200 shares that cost you $75 ([100 + 50] / 2 = 75), do it again and your cost is around $66 ([100 + 50 + 50] / 3 = 66.67-ish). So you may be able to safely sell covered calls or sell yet another put and lower your overall cost.
Now that’s how you handle it if the price has dropped but the two things you can do before it happens are these:
- Only trade 10% – 30% of your account balance at a time. That way you still have money to trade.
- Buy put hedges when you sell the put. When you place your order to sell the put, you can also buy some puts that are a few months out to use as a hedge if the stock tanks. You would then sell those puts to help recover funds and reduce your losses. At a few months out, you only need to buy the put hedges once, and sell puts like normal until the expiration for the put hedges come close to expiring. Then you can either roll them or let them expire and buy new ones a few more months out.
In Conclusion
Welp, that about wraps it up. There’s several courses on the Wheel Strategy, both free and paid that go into trading this strategy step-by-step and both Peter Pru and Karl Domm have excellent courses.
I’ve also created a FAQ for the Wheel Strategy: https://jeffwood.com/4179/the-wheel-frequently-asked-questions-faq/