Understanding Wheel Strategy

Options trading is a popular way many investors trade their assets across different markets. Among the many options trading strategies is the wheel strategy. Though initially designed for stock trading, this technique has permeated into other markets. In this article, we will take a comprehensive dive into wheel strategy as a crypto trading tool, looking at how it works, as well as its potential risks and rewards. 

What is the Wheel Strategy?

Wheel strategy similar to other options focuses on speculating the price movement of a crypto asset without actually owning it. This way, the trader bets on whether the price of the asset will rise or fall within a specific timeframe and profits on selling options on assets that other traders are bullish on. 

The wheel strategy relies on put options and call options.

• Put Options: These options allow the trader to sell an asset at a certain strike price (the predetermined price at which an asset can be purchased or sold before it expires) within a specific period. It is particularly used when a trader anticipates a price decrease. 
• Call Options: Call options enable a trader to buy an asset at a certain price within a given time, these options are often used when the price of an asset is anticipated to rise. 

The wheel option strategy is best for traders with a working knowledge of options trading. In other words, one must be experienced in options trading to be able to know when to buy a crypto asset when a short put expires in the money and sell it when a short call expires in the money. 

Benefits of the wheel strategy

The wheel strategy offers several advantages for traders.

• Consistent Income. This strategy provides traders with a steady and reliable income, making it an attractive strategy to many traders. 
• Flexibility. The wheel strategy is quite flexible, allowing traders to adjust their trading positions and strike prices with market conditions and volatility. 
• Lower Risk. When compared to other strategies, the wheel strategy has a lower risk attached to it.
• Lower costs. This options strategy enables traders to offset potential price declines while increasing net sale price. 

Applying wheel strategy

The wheel strategy is dependent on employing two techniques in a cycle/wheel: selling put options and selling call options. This technique allows one to create revenue through ongoing trades. The following steps will help you in applying the wheel strategy. 

Step 1- Find the right crypto asset

The first step of any investment strategy is always choosing the right asset to invest. No matter which crypto asset you choose, you must go with a stable one that has growth potential, especially if you are hoping for long-term profitability. 

Another factor to consider when selecting your asset is to find one with high liquidity. A high liquidity asset indicates a significant level of trading activity making it easier to find a buyer or seller.

Step 2- Selling cash-secured put options

The second step in the wheel strategy comprises selling cash-secured put options. A cash-secured put involves writing an out-of-the-money (current market price is lower than the option’s strike price) or at-the-money put option (strike price is at or very near to the current market price) in order to assign and obtain an asset below the current market price. 

In this step, a trader agrees to buy their desired asset at a specific strike price once it falls below a certain level. This must be done before the expiration date and must have enough to cover the cost of the purchase. 

The process starts with selling a cash-secured put option on an asset and collecting the premium. One should only go for assets they are confident in and can hold over time. 

The formula for calculating this would be (Strike Price – Settlement Price + Premium Received). For example, when a trader sells 1 ETH at a $10,000 put option and receives a premium of $2,000 from the buyer and the contract expires at a settlement price of $9,000, the seller will be credited +$1,000 in their account. 

Once you sell a put option, all that is left is to observe the asset’s price and wait. There are two ways this can go.

• The asset’s price goes lower than the strike price. When this happens, the trader must buy the asset at the strike price. With stocks, the trader will be required to buy 100 shares at the strike price. The trader gets to keep the premium, enjoy the discount, and reduce the overall costs. 
• The asset’s price goes higher than the strike price. When the put option expires worthless (goes into expiration out of the money and disappears from your trading account) the trader can also keep the premium, use it to offset the cost of purchase, and continue the put selling cycle.  

After this, the seller can enter the market and buy the ETH before moving to the second stage. Additionally, if the trader already holds an underlying crypto asset, they can skip this step and move straight to the next one. 

Choosing which put option to sell

Choosing a put option is dependent on the following.

How far the current market price is lower than the option’s strike price (out of the money). If the aim is to get a premium and allow the option to expire worthless, the asset should be sold with a strike price below the current market value. The lower the strike price the lesser the chance the option will expire in the money. However, this will result in a lower premium. On the other hand, if you want to buy. the underlying asset, the strike price should be higher than the current market value. 

How many days to expiration (DTE) the option has. Always consider how the put option premium changes. As the option draws closer to expiration, it will lose value and this can be measured using Theta. Theta is used by traders to measure an option’s declining rate over time.  Theta is lower for options dated longer and higher for those with a near date. 

Step 3- Selling covered call options

After the successful completion of the second step, the trader can now sell covered call options. In this step, the trader provides someone else the opportunity to buy your asset at a set strike price. This predetermined price is usually the same as or higher than the purchase price. If the asset’s price is higher than the call strike price you will have to sell the asset at the predetermined price.

Two potential outcomes can arise in this step.

• The asset’s price remains below the strike price, resulting in the call option expiring worthless and the trader retaining the premium. 
• The asset price is higher than the strike price. This means the trader has to sell at the predetermined strike price. When this transaction is done, the process can start over.

Ideally, you want to ensure the covered call is sold with a strike price that’s lower than the cost. 

Choosing which call to sell

The same factors considered when selling a put are used when choosing which call to sell. You will still need to give thought to how far out the money the strike price has to be and how many expiration days the option must have.

Step 4- Repeating the cycle

Wheel strategy is favored by many due to the fact the process can be repeated severally. No matter which way a trade goes, you can still use the strategy to gain your desired outcomes. All you will need to do is begin the process again. The wheel strategy cycle only ends when the asset is called away from you.

You must remember to keep track of your profits or income received during each of the steps to know if your position is profitable in the long run. 

Making adjustments in bearish markets

Options are flexible allowing traders to make adjustments when the market conditions are bearish. For example, if ETH is trading at $10,000 and a trader sells  1 ETH at $8,000 with a 40 DTE, they will receive a premium of $2,000. 

If within the contract, let’s say at the 20 DTE the trader becomes bearish and the underlying price falls by $1,000 (the premium remains the same) there are three ways they can adjust their position. 

Purchase a protective put option at a lower strike price

This means that the trader uses the Bull Put Spread strategy by converting the cash-secured short put into a lower strike price. The protective long put caps how much you lose from the short put and serves as a risk management tool by capping the potential loss from the short put. Since the strike of the protective put is lower, the cost of obtaining it will typically be less than the premium received from the written short put.

Close the position and later sell a lower strike

This way the trader has the option to sell a put option with a lower strike price. The new option should have a similar DTE, allowing the investor to reduce their breakeven price. Additionally, by selling the lower strike put, the investor can generate premium income equivalent to the amount collected with the initial put. This strategic move provides flexibility in adjusting the position and potentially improving the overall risk-reward profile of the trade.

Roll down

Rolling down in options trading entails closing an existing short position at a specific strike price and simultaneously opening a new short position at a lower, more out-of-the-money strike. In this case, the trader can execute a rolling down strategy by repurchasing the 1 ETH at $8,000 put and simultaneously initiating a new short position with a strike closer to their bearish sentiments. 

Since the new strike is further out-of-the-money, it generates less premium and has a lower theta. However, the advantage lies in the lower delta of the new strike, making it less prone to expiring in the money. 

This strategic move allows the investor to adjust their options position based on market conditions and potential price movements, balancing the trade-off between premium income and risk exposure.

Potential returns

The outcomes of employing the wheel strategy are subject to various factors that can potentially enhance potential profitability. 

• Timing implied volatility. Traders must sell options during periods of elevated implied volatility compared to historical norms. This can significantly impact the effectiveness of the strategy.
• Premium collected. The success of the strategy hinges on the cumulative premium collected over time. A higher premium collection increases the likelihood of success as options expire worthless.
• Predicting trend reversals. Better returns depend on the successful identification of points of a trend reversal in the underlying asset’s price. The strategy aims to “buy low and sell high,” strategically selling puts near range lows and calls near highs to optimize profitability.

Understanding potential losses

The wheel strategy has potential losses and understanding these losses can be categorized into two. 

Cash-secured put

To understand the maximum potential loss in a cash-secured put, the difference between the strike price and the settlement price plus the premium received is calculated. The maximum loss occurs if the underlying asset price drops to $0.00. For example, if a short $10,000 put option is used with a premium received of $1,000, the maximum loss would be -$9,000 (-$10,000 + $1,000). To mitigate the risk of the maximum loss, it is advisable to close the position if either the premium or the underlying asset reaches a predetermined price threshold.

Covered call

The difference between the cost of acquiring the underlying asset and $0.00, plus the premium received reveals the maximum loss in a covered call strategy. For example, if 1 ETH is bought at $10,000 and sold as an out-of-the-money call option, receiving a $1,000 premium, the maximum potential loss would be -$9,000 (-$10,000 + $1,000). To manage this risk the trader should set a stop-loss order against the underlying asset. If triggered, this order would prompt the immediate closure of the short call option position, helping to limit potential losses.

Wheel strategy indicators

There are several indicators one must understand when using the wheel strategy.

The Delta metric

The Delta metric in the wheel strategy is used to measure the rate of change in an option’s amount and the probability the option will expire in the money. It is also used as an indicator of stock ownership. 

Delta is typically indicated by numbers ranging from 0 to 1. Call options change with the underlying asset price positively and have positive deltas ranging from 0 to +100. This means if the price rises the call Delta rises and vice versa. In other words, delta informs us how much the price will rise if the asset is higher by $1 or drops by the same amount. 

Conversely, put options have positive deltas ranging 0 to -100. This is because they have a negative relationship with the underlying asset price i.e. if the price rises the put delta falls, and if the price falls the put delta rises. 

Delta decreases when a call option moves further out of the money and increases when a call option moves deeper into the money, the opposite being true for put options.

Wheel strategy sweet spot

Similar to other options strategies, the wheel strategy also has a sweet spot. A sweet spot in options trading refers to the optimal entry and exit points of a trade. These points are based on charts and other technical indicators. 

The wheel strategy has two main sweet spots. 

• Covered Call Sweet Spot. This sweet spot happens when the call option expires worthless (at the money). This means that the seller can keep the premium and the value of the asset remains high. However, the call option has to be out of the money when sold. 
• Cash-Secured Put Sweet Spot. This sweet spot is seen when the underlying asset price is the same as the strike price. The option expires worthless and the trader can keep the premium. 

Breakeven Point

Another factor to consider in wheel strategy is the breakeven point. In options trading, the term breakeven is indicated when the underlying price of an options contract must be reached by the option’s expiration so that the owner of the option avoids losing money on its purchase.

When working with the wheel strategy option, the cost of acquiring the underlying asset should be factored into the calculation. For example, a cash-secured put will reach the breakeven point when it expires below the strike price (in the money) equal to the premium received. If a trader sells 1 ETH at a $10,000 put option, the breakeven point will be $9,000 after receiving a premium of $1,000. 

The seller will probably buy the underlying crypto asset when the put expires. Otherwise, the purchase will be at the same level (no change/no profit) or above the settlement price (at a loss).  To minimize risk, you will need to purchase the underlying asset as soon as the short put option expires in the money. 

A covered call breakeven point happens when the premium is no longer sufficient to offset a decline in the underlying asset’s value when the option expires. For example, if the trader above buys 1 ETH at a $10,000 and sells an out-of-the-money call option at $9,000 and gets a $1,000 premium, the breakeven point will be $9,000 as the premium will offset the price drop.

Theta Decay Impact

Theta decay enhances the effectiveness of the wheel options strategy by decreasing the value of written options as their expiration approaches. A trader can capitalize on the steepest part of the decay curve by selling options with 30-40 days to expiration. 

Volatility Effect

Volatility gauges the rate and speed at which the price of an asset moves within a specific time frame.  Markets with minor day-to-day price fluctuations have low volatility, while those experiencing larger swings are considered high volatility. 

In options trading, volatility is characterized as:

• Historical Volatility, which measures how much the price changed day to day over a specified historical period. 
• Implied Volatility (IV), which measures the anticipated future volatility of the underlying asset in the options market. When all other factors remain constant, option prices increase with a rise in implied volatility and decrease when implied volatility does. 

Historical volatility and implied volatility influence one another and understanding how they interact can help you gauge whether implied volatility is high or low using historical data. 

Some traders choose to sell options when implied volatility is higher than historical volatility. This helps to gain higher premiums and maximize profits should implied volatility revert to its historical mean. 

Take profit potential

The maximum take-profit potential in the wheel strategy can have three main possible outcomes. 

• The short puts never expire in-the-money, allowing the option writer to consistently generate a steady and reliable income. This is an ideal situation. 
• Continual covered calls with rising underlying asset. The trader can continually write covered calls if the underlying asset trends higher. Here, the covered calls rarely or never expire in-the-money, and the trader profits from capital appreciation and the consistent income from writing the covered calls. 
• Short put expires at-the-money/expires worthless. When this happens, the option writer retains the premium and purchases the underlying asset which experiences an appreciative rally. They can then benefit from this capital appreciation by writing covered calls and generating additional income through received premiums.

Factors to consider when using the wheel strategy

To successfully implement the wheel trading strategy, consider the following factors. 

Confidence in the underlying crypto asset

You must have enough confidence in the underlying asset. Given that the asset can be assigned through the put option, you should be confident enough to hold the asset for an extended period.

Timing

The timing option in the wheel strategy plays a critical role. Options usually lose value as they approach expiration. Therefore, selling puts with a near-dated expiration, typically within the range of 30-40 days, allows traders to capitalize on time decay. This strategic timing enhances the potential for maximizing premium returns.

Strike prices

Choose strike price options that align with not only your long-term investment goals but also your risk tolerance. Your choice of strike prices should represent levels at which you are comfortable holding the underlying asset for an extended period.

Cash in the trading account

One of the most crucial factors in the successful implementation of the wheel strategy is having adequate financial capital in your account. This will help cover any potential losses should the option expire in-the-money and you are assigned the underlying security. In other words, you need to be cash-secured to execute the strategy effectively.

Wheel strategy cons and risk management

Despite its advantages, it still presents some disadvantages. 

Potential Losses

Despite its risk mitigation features, the wheel strategy is not immune to losses. It still faces the same unfavorable market conditions or unexpected events, which can still lead to financial setbacks.

Effect of rising implied volatility

The wheel strategy is susceptible to the impact of rising implied volatility. An increase in implied volatility can lead to higher option premiums, but it also heightens the risk for the option seller. This rise in volatility can result in larger price swings, potentially working against the strategy and affecting both the short put and covered call components.

Holding periods

If you choose the wheel strategy, you must employ patience. This is because you could experience a longer holding period, especially if the asset’s price experiences a decline. Again, confidence in your underlying asset is paramount. 

Cash Settlement

Due to the nature of cash settlement in options, investors using the wheel strategy may need to execute additional transaction costs from buying or selling the underlying asset. 

Upside potential vs downside risk

While a trader/investor is bound to enjoy a steady income stream, the cash-secured put and the covered call components of the wheel strategy come with limitations on potential gains. Additionally, if the market experiences unexpected declines or adverse events, this strategy exposes the trader to significant downside risk.

Limited gains

Even with the benefits of a steady income, the wheel strategy may not maximize profits during strong bull markets. Investors seeking substantial capital gains might find the strategy relatively conservative in comparison to more aggressive trading approaches.

Understanding and acknowledging these potential downsides is crucial for traders considering the wheel strategy. Similar to other trading or investment approaches, a well-informed and balanced strategy that considers both advantages and drawbacks is key to success.

Managing potential risks

The wheel strategy is not immune to risks. However, there are ways to mitigate these risks. 

• Have a clear understanding of your risk tolerance and select strike prices based on your comfort level. 
• Choose write options ranging between 30 and 40 days to expiration. This will help you maximize time decay.
• Look for crypto assets with strong fundamentals, a history of sustained growth, and anticipated future strong performance.
• Diversify and stay informed about market developments. 
• Sell put or call options with a chosen strike price that you anticipate will expire at-the-money.
• Constantly monitor your crypto assets and adjust accordingly if market conditions or asset performance shift. One way to do this is to set up notification alerts. 
• Sell options during periods of elevated implied volatility compared to historical volatility.

Wheel strategy vs alternative strategies

Due to the restricted upside potential and notable risks associated with the short option components of the wheel strategy, it may not be well-suited for investors with lower risk tolerance. Understanding the fundamental characteristics of the strategy can help look for alternative strategies with varying risk profiles.

Buy And Hold

Sometimes, the traditional buy-and-hold strategy may be more profitable, particularly for risk-averse investors. While selling put options is profitable if the market moves higher (with the put expiring worthless and retaining the premium), it caps potential profit at the received premium. If there’s a belief that the underlying asset’s price could rise more than the put option premium, outright asset purchase might be more sensible.

Credit spread

A credit spread is an options strategy that involves two legs, where an investor sells one option and concurrently buys another option that is further out-of-the-money in the same underlying asset, and both options share the same expiration date. 

In a credit spread, the short option is consistently positioned closer to the money (at a higher strike price) than the long option. This arrangement leads to the short option having a higher premium compared to the premium of the long option. 

For instance, if 1 ETH is sold for a $10,000 put option with 40 days DTE and receives a premium of $1,000 and 1 ETH is bought at a $9,000 put option with 40 DTE and gives a premium of $500, the trader will receive a net credit of $500 (premium received- premium paid).

The primary distinction between short options in the wheel strategy and a credit spread lies in the fact that purchasing the further out-of-the-money strike in a credit spread limits potential losses to the difference between the strike prices, minus the premium received.

Looking at the example above, when using the wheel strategy, the trader receives a $1,000 premium but only $500 with a credit spread. However, the potential loss with a credit spread remains at only $500 as opposed to the $9,000 with a wheel strategy. 

Collar Options Strategy

The Collar Options strategy is mildly bullish and low-risk and is designed to protect against large losses. With this strategy, the trader purchases the underlying asset and a protective out-of-the-money put option and sells an out-of-the-money covered call. 

For example, a trader may buy 1 ETH at $10,000, another ETH at $9,000 put option with 40 DTE, and pay a $500 premium, then sell 1 ETH at $10,000 call option with a 40 DTE and receive a premium of $1,000. 

Risk reversal options strategy

The risk reversal options strategy involves the simultaneous purchase and sale of options to establish a position with a predetermined risk-reward profile. Typically, this strategy entails buying a call option while concurrently selling a put option, or vice versa.

Investors employ risk reversals to articulate a directional perspective on an underlying asset, effectively manage risk, and potentially capitalize on market movements while minimizing initial costs.

For example, if a trader sells 1 ETH $9,000 put option with a 40 DTE and receives a $1,000 premium and buys 1 ETH $10,000 and pays a $1,000 premium the cost (premium paid – premium received).would be $0. 

If the option expires between $9,000 and 10,000, they will not make any losses or profits. They would have an unlimited upside potential above $10,000, and a significant downside potential below $9,000.

Bottom line

The wheel strategy options trading though highly beneficial can be very technical, making it suitable for traders who have experience with options trading. You must understand the different factors and variables that can help improve your odds. To benefit from its steady income, the strategy requires you to carefully choose assets, analyze the market, and employ patience.