The Wheel Strategy (Passive Income Strategy)

The wheel strategy is a strategy that combines two options strategies: selling call options and selling put options. Before deciding on which stock to use this strategy on, it is important to choose a stock that you do not mind owning over the long term and has solid fundamentals. In this example, we will use 100 shares of $BA. (Note: 1 option contract represents 100 shares of the underlying stock).

To start, we need to look at the current price of the underlying stock. In this example, $BA is trading around $180. (It is common to look three months out from the strike price to decide on which contract to sell. You can also sell contracts on a weekly basis).

Selling Put Option Contracts

Selling put options involves selling a contract that gives the buyer the right, but not the obligation, to sell a specific asset at a predetermined price (also called the “strike price”) on or before a specified expiration date. The person selling the put option is also known as the “writer” or “seller,” and receives a premium payment from the buyer in exchange for taking on the obligation to buy the asset at the strike price if the buyer exercises their right to sell.

Your broker may require a form of collateral to execute a trade involving selling put options. For example, in this scenario, the brokerage would require $18,000 in cash to execute the trade, enough to cover the 100 shares in the contract since you are obligated to buy the asset if the price falls below the strike price.

Fair Warning: It’s worth noting that if the share price falls below the put strike price that you sold, you are still obligated to buy the stock at the strike price you sold. For example, if $BA is at $180 per share and you sold a $175 strike put contract, and $BA falls to $165 per share, you are still obligated to buy the 100 shares on the expiration date at $175 and you have incurred losses.

Here is a clearer example of a scenario where you are not required to buy the 100 shares:

1. Identify the stock: You own 100 shares of Boeing stock and would like to generate income from their position.
2. Determine the strike price and expiration date: You decide to sell put options with a strike price of $180 and an expiration date in three months.
3. Sell the put option: You sell one put option contract, which represents the right to sell 100 shares of Boeing stock at the strike price of $180. You receive a premium payment of $50 from the buyer of the put option.
4. Hold onto the stock: You hold onto their 100 shares of Boeing stock until the expiration date of the put option.
5. Evaluate the outcome: At expiration, the price of Boeing stock is $200. The put option buyer does not exercise their right to sell the stock, as the market price is above the strike price. You keep the premium of $50 as profit.

Hypothetical: Now let’s say you have been obligated to buy the shares and now own 100 shares of $BA. You have received the premium from selling the put options.

You can now sell covered calls against the shares you own at a higher strike price than what you have been obligated to buy the shares at.

Covered Call Strategy

The covered call strategy is a popular options trading strategy that involves selling call options on a stock that you already own. The strategy is often used to generate income from your existing portfolio, as the premium received from selling the call option can provide a steady stream of income as long as the underlying stock remains relatively stable. Here’s how the covered call strategy works:

1. Identify a stock that you already own and would like to generate income from.
2. Determine the strike price and expiration date of the call option you would like to sell. The strike price is the price at which the option holder has the right to buy the underlying stock, while the expiration date is the date on which the option contract expires.
3. Sell the call option on the stock. You will receive a premium payment from the option buyer, which is the price of the option.
4. Hold onto the stock until the expiration date of the call option. If the stock price is below the strike price at expiration, the option will expire worthless and you will keep the premium as profit. If the stock price is above the strike price at expiration, the option will be exercised and you will be required to sell your stock at the strike price, but you will still keep the premium as profit.

The covered call strategy can be a useful way to generate income from a portfolio of stocks that are expected to remain relatively stable. However, it’s important to keep in mind that selling call options also carries some risks. If the stock price makes a significant move higher, you may miss out on potential profits from the stock’s price appreciation. Additionally, if the stock price falls significantly, you may suffer losses on both the stock and the call option.

Once again, a clearer example (based on you now owning 100 shares from selling the put option contract (From in “Fair Warning” You own shares now!)):

1. Identify the stock: You now own 100 shares of $BA stock and would like to generate income from your position based on being forced to buy 100 shares.
2. Determine the strike price and expiration date: You decide to sell call options with a strike price of $200 (higher than what you were forced to buy 100 shares at) and an expiration date in three months.
3. Sell the call option: You sell one call option contract, which represents the right to buy 100 shares of Boeing stock at the strike price of $200. You receive a premium payment of $75 from the buyer of the call option.
4. Hold onto the stock: You hold onto the 100 shares of Boeing stock until the expiration date of the call option.
5. Evaluate the outcome: At expiration, the price of Boeing stock is $180. The call option buyer does not exercise their right to buy the stock, as the market price is below the strike price. You keep the premium of $75 as profit.

Conclusion:

Overall, this strategy is based on selling option premium and hoping the option contracts expire worthless. If you are forced to buy the 100 shares from selling the put contract, then you can deploy the covered call strategy. This is the reason why you want to do this on a stock that you believe in for the long term, just in case the strategy doesn’t work out and you are stuck with owning 100 shares in the company.

Disclaimer: The content of this article is for informational purposes only and is not intended as financial advice. Any investment decisions made by the reader are their own responsibility and at their own risk. The author and any third parties mentioned in this article do not endorse or recommend any specific financial products or services, and the information provided should not be relied upon as the sole basis for making any financial decisions. It is recommended that readers seek independent financial advice from a licensed professional before making any financial decisions.