Two Paths for a Wheel

Fifty Ways to Trade an Option

The wheel can take you many different directions. 

After mastering the covered call, the wheel trade is the next logical step for traders and investors looking to push the risk spectrum further. 

A major advantage of this structure is that it fits into our stock picking intuition. The derivatives are priced using higher order expectations about volatility, but mostly you just want a stock that will go up. 

A stock going up that also has over priced options - positive volatility risk premium edge. All option trades are volatility trades, and you want to pick the fattest pitches.  The wheel is a stock direction wager for each instance, but over time it is VRP and beta capture. 

When selling a put in the first leg, you're using the short put strike’s worth of capital. How much less than the stock price will depend on the tenor and delta. 

This framing - driven by capital requirements - is part of why we think about using the wheel trade to buy stocks at a discount. The further out of the money, and lower delta, the greater the discount. Longer dated options have wider distributions, thus putting that fixed fifteen or thirty delta option further away from the money. 

Another way to consider the above chart would be to say there’s a roughly 15% chance that you can buy BAC at a 9.68% discount on expiration in 60 days. There’s a ~30% chance you can buy it for a 1% discount at expiration in 10 days. (Both of these are at expiration - there’s approximately double that chance it touches at some point.)

Selling a put is offering out a limit order to buy stock at a given price in the future. In return for being on the hook, you get paid a small amount of premium. The compensation for putting your stock bid in place is the cash that goes into your margin account alongside that contract. 

As a percentage of the stock price, these premiums increase over time alongside the discount, but the scale here is completely different. While these do reduce your basis below that strike price or discount mapped in the first chart, at 15 delta and 60 DTE, the 80bps you’re getting is less than 8% of the total reduction in cost basis. 

If you’re assigned, most of the potential profit is going to come from stock direction. Buying at a discount and hoping for a rebound to sell out with your call. However, to further contextualize the premiums,. 54 bps every 30 days in $BAC annualizes at 2.5x better than their dividend rate. 

Would you rather make your money on premium or stock direction? Both are effective ways to trade the strategy, but require their own nuances and expectations. 

Today in Fifty Ways to Trade an Option, we’ll talk about the differences between premium collection and stock movement when trading the wheel.