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Wheel Strategy: Utilizing Option Trading Mechanics

| by
Joel Agbo

Key Takeaways

  • Options trading allows traders to generate profit by owning rights to buy (calls) or sell (puts) an asset within a stated period after which the contract expires.

  • The goal of the wheel strategy is to utilize puts, calls, contracts, and strike prices in a recurring pattern to generate consistent profits through premiums and contract risk hedging. 

  • Before trying out the wheel strategy, ensure that you’ve done your research into the asset and contract, and check that you have sufficient risk management provisions in place in case things go south. 

Wheel Options Strategy

The wheel strategy (also known as the "wheel options strategy") combines every principle of contract trading to develop a trading system that limits risks. The wheel strategy seeks a modified version of the traditional ‘buy low-sell high’ strategy by utilizing options trading mechanics and risk-management strategy on asset holding.

The wheel strategy aims to minimize losses and helps traders to acquire assets at a discount through a calculated application of options contract trading principles. These principles include contract validity, pricing, and reselling. Options trading and the wheel strategy are native to the traditional stock trading markets but have also been adopted by cryptocurrency trading platforms and are relevant tools in the crypto space. 

Understanding Options 

Let’s run through what options are. As the name suggests, "options" let traders generate profit by owning rights to buy an asset within a stated period after the contract expires. 

A holder buys the contract from the issuer and has the right but not the obligation to purchase the asset attached to the contract. The issuer is obligated to fulfill the terms of the transaction (selling or buying,) if the holder exercises their options. However, this privilege doesn’t come for free: the buyer has to pay a fee known as a premium to the issuer. This fee is non-refundable, regardless of whether the option is exercised, and is considered the cost of the contract. 

Options contracts are referred to as "call options" or "put contracts" depending on the prevailing agreements and the direction of the contract.

Call Options

A call option contract is written by an asset owner who wishes to put their asset up for sale at a stated price. This price is known as the "strike" price (the price at which the issuer wishes to sell their asset), and the sale is valid for a stated time, within which the contract buyer can purchase the underlying asset. A call option gives the holder the right but not an obligation to buy the underlying asset, while the issuer has an obligation to release these assets when the contract buyer wishes to purchase them based on the terms of the contract.

This depends on whether the options purchased are American, where the buyer can exercise their right to purchase any time up till expiry, or European, where the right to purchase can be exercised only on the expiry date. This in turn ends up affecting the premium paid. 

For instance, a Tesla stock owner who wishes to sell his stocks via an American option contract at $400 per share valid for a year, writes a call option marked as 1 TSLA 400. $400 is the strike price. The contract is worth $40,000 ($400 * 100 shares). If the issuer decides to charge a premium of $5 per share, the buyer will pay a premium of $500 to the issuer to own the contract.

In a case where Tesla shares rise to $500 per share before the 1-year period elapses, the contract owner reserves the right to trigger the purchase and make a profit of $100 per share ($10,000). The net profit however is the total profit minus the premium paid. Call options holders will hope that the underlying assets grow in price before the contract expires, else they might be left with only one choice; to forfeit the premium and let the contract expire.

A call option contract is said to be "in the money" (ITM) when the strike price is above the normal price of the underlying asset. For the instance above, the contract is ITM as long as Tesla shares stay above $400.

However, when the price of the underlying asset goes below the strike price, it is said to be "out of the money."

Options traders can take a long or short position on call or put options. A long call position is a bet on the ability of the asset to grow in price. A trader in a long call position has the right to buy the asset at the strike price. A long-call position holder is the holder of the contract.

On the other hand, a short-call position gives the trader an obligation to sell the shares at the strike price. A short call position is a bet on the asset’s price dropping. The short-call position holder is the issuer of a call contract. A short-call position holder runs the risk of the value of the asset rising within the contract validity period.

Covered Calls

A call option issuer, knowing of their obligation to sell the underlying asset (should the holder decide to exercise their purchase right) may decide to cover for a potential loss by holding a long position on the same asset, or simply purchase the asset earmarked to the options contract. If the asset grows in price, the issuer takes a loss on the options contract but profits from the long position, which may offset some of the losses. Similarly, holding the asset allows the issuer to fulfill the call option without having to incur losses by purchasing the asset at a higher price on the market. This is known as a covered call. The long position serves as a hedge for losses that might emanate from the options position, while the issuer seeks to profit off the premium paid by the contract buyer.

Put Option Contract

Put contracts give the holder the right to sell the attached asset within the contract validity period at the specified strike price; they are however not obliged to do this. The contract issuer is under an obligation to purchase the asset if the holder wishes to sell them within the contract’s validity period. Again, the buyer has to pay a premium to the contract issuer for this privilege.

The put contract is the opposite of a call contract. The issuer pledges to purchase an asset at a price specified by them within a period. Even if this asset’s price drops below the strike price, they are still committed to buying the asset at the strike price. The contract holder, therefore, hopes that the spot price of the attached asset drops within the contract validity period as this keeps them "in the money."

A put option contract is said to be ITM when the strike price is below the normal price underlying asset. For the instance above, the contract is ITM as long as Tesla shares stay below $400.

However, when the price of the underlying asset goes above the strike price, it is said to be "out of the money."

Cash-Secured Puts

Cash-secured puts are ‘backed’ in cash by the contract issuer. A put contract issuer is aware of the fact that they are obliged to purchase the underlying asset if the contract owner decided to assign the asset within the validity period of the contract. A cash-secured put is a way of limiting the risk involved in the trade. To write a cash-secured put, the issuer keeps an equivalent of the contract’s value (Strike price * 100) in cash reserves so that they are financially ready to buy the asset should the option be exercised.

Instead of buying the asset on spot markets, a cash-secured put issuer may decide to write a contract with the strike price below the current value of the asset on spot markets (this is known as an "Out of The Money" contract) and set aside the contract’s value. This places them on two advantage levels should a buyer pay for the contract. First, the issuer gets paid a premium by the holder. If the holder assigns the asset, the issuer buys them below the price they could have purchased them for on spot and retains the premium paid as well. If the contract expires without the assets being assigned, the issuer leaves with their premium and cash reserves.

However, if the asset grew considerably in price within the contract period, the issuer still gets to keep the premium but loses out on the profit they could have made if they purchased the asset on spot at that time.

Cash-secured puts are a minimized risk strategy for asset acquisition.Another way to mitigate risk in options trading is through the wheel strategy. The wheel strategy is native to tradfi derivatives markets, but can also be applied to cryptocurrency trading. Now that we’ve covered the basics of options trading, let’s dive into the wheel options strategy.

The Wheel Strategy

The wheel strategy combines puts, calls, contract validity, and strike price principles in a recurring pattern to generate consistent profit through premiums and contract risk hedging. In the wheel strategy, the user plays the options trading cards to issue options contracts, trade them for premiums, and hedge the risks in such a way that any losses incurred at any part of the trade can be offset by the premium or the hedge and still leave room for profits, even if they are minimal.

Example of Wheel Strategy

Chart from GeckoTerminal

It is a tactical trading pattern that attempts to earn recurring profits through repeated trading patterns while ‘staying in business’. The wheel strategy consists of two stages, each stage playing a different card but sticking to the options trading rules.

Stage One

In the first stage of the wheel strategy, a contract issuer sells an "out of the money" put contract. The trader reserves the cash equivalent of the options so as to be able to purchase the options when they eventually get assigned, this contract is known as a cash-secured out of the money contract. As described earlier, this contract is set at a strike price below the spot price of the asset. The issuer receives a premium from the contract buyer.

For instance, an options trader writes a contract for bitcoin at a strike price of $16,900 while bitcoin trades at $17,400 on spot markets. Assuming he receives a premium of $5 per bitcoin in the contract, a total premium of $500 (5 * 100).

The issuer’s profit from the contract is tied to two scenarios.

First, the asset rises in value (in our instance, bitcoin trades at $17,500) and the contract expires at a price above the strike price (out of the money), so the holder leaves the contract validity period to run out without assigning the assets as this is a more profitable move. In the second scenario, the asset’s value falls below the strike price ( say Bitcoin trades at $16,800 before the contract expires) and the issuer gets assigned to purchase the asset at the strike price (in the money).

In the first case, the issuer leaves with a premium and makes a net profit. In the second scenario, he purchases the asset at a discount but also at an unrealized loss relative to the current value of the asset.

The main approach in the first step is to continuously write and sell ‘out of the money’ contracts until the second scenario occurs and the trader gets assigned to purchase the asset. When this happens, the trader buys the asset using their reserved funds, keeping the collected premiums and moving on to the next stage of the wheel.

Stage Two

Moving on to Stage 2, the trader has purchased the asset at the strike price from Stage 1. In our instance, the trader will purchase 1 BTC at $16,900. In the second stage, they sell covered calls. If possible, this is done repeatedly as the issuer continues to sell the call contracts and receives a premium. The contract is written with the strike price above the value of the asset on spot markets.

Using bitcoin as an example, the contract issuer sells their contract at a strike price of $17,200 while bitcoin trades at $16,800 on spot markets. The buyer pays a premium to the contract issuer and believes in bitcoin’s ability to rise above this level.

If bitcoin fails to cross this level within the contract validity period, the buyer leaves the contract to expire, and forfeits their premium to the issuer who continues selling more calls until the second scenario happens.

In the second scenario, the asset grows in price and exceeds the strike price. Let’s say bitcoin pumps to $17,800 within the contract validity period. The contract buyer exercises his right to purchase the underlying bitcoin. The contract issuer sells the assets at a loss relative to the current market price. But the contract is covered; the issuer has already set the asset aside or has a long position of the same magnitude. This covers the losses and the issuer profits off their premium and moves to stage 1 again, and the wheel continues.

Considerations Before Using the Wheel Strategy

The wheel strategy has an array of advantages, for each scenario, the issuer who applies a wheel strategy in their trading stands to gain in different ways. If the option expires worthless, the issuer gains a premium. On the other hand, the issuer purchases the asset at a discount if the contract expires in the money and they are assigned a purchase. 

Some shortcomings of the wheel strategy is that in the event the issuer has to purchase the asset at a discount, they are also purchasing it at an unrealized loss relative to the current value of the asset until the asset rebounds. If it falls further, their loss will continue to grow. 

Premiums for "out of the money" options are also relatively small, and may possibly require multiple iterations, which opens you up to more risk over a longer time frame. 

Also, improper selection of strike prices may result in a net loss of there is a large plunge or spike. 

If you are planning to try out the wheel strategy, here are some additional considerations:

The Size of Your Account

An options trade allows you to wager on 100 pieces of an asset at once. That is, a TSLA or ETH Option contains 100 Tesla shares and Ethereum respectively sold at the strike price. Before entering an options trade, therefore, it is important to ensure that your trading account is at least 100 times larger than the value of the asset you plan to trade using the wheel strategy.

The Asset to be Traded

If you are not able to access a large amount of money and information for your options trading adventure, it is very important to consider the value of the asset you are trading and how much you understand its price development pattern. Check the assets available to trade and consider trading price relative to your account size and also consider your knowledge of the asset before choosing them for your trade.

The Contract Validity Period

The validity period for your contract is an important parameter to consider. An overly wide contract validity period gives the asset enough time to swing across price levels. The holders also have enough time to wait on price development. For volatile assets like cryptocurrencies, this gets even more important. However, setting a validity period that is too short would result in much lower premiums, that may not be worth the risk.

The Premium Charged

How much are you looking to charge a buyer for your contract? It is important to set a premium that can cover a tangible portion of your losses (if any), return reasonable profits, and doesn’t scare buyers away while doing both or any of these. Specify a reasonable premium that works for you and the potential buyer as well. After all, while you can set your buy and sell price for premiums, potential buyers will accept based on what the market is charging, along with other factors like Option Greeks. The Greeks are variables that can impact the price of the option, like time to expiry or price of the underlying asset. 

Risk Management Provisions

How solid are your cash reserves for a cash-secured put and how do you hope to plan your long position for a covered call? 

How long do you plan to run the wheel strategy? You may want to consider setting your take-profit levels, or your time frame to exit.

How long can you afford to hold on to unrealized losses? In an extended downtrend, uptrend, or sideways market, it will take time before the market changes course. 

Apart from these, your understanding of the risks involved in options trading and how you work against these risks is paramount to succeed with this strategy.

Wheel Strategy vs. Buy and HODL

The wheel strategy is a relatively active profit-seeking strategy. Traders using this strategy are in consistent trading with the hopes of making profits along the line. In contrast, "buy and HODL" traders purchase the asset and keep them until a certain level where they decide to sell them off. The wheel option on the other hand tries to make profits from the assets instead of keeping them dormant.

Wheel options through cash-secured puts give a trader an option to buy the asset at a discount, and also lessen their loss levels through premiums. The risk involved in both strategies might be a bit complicated to calculate. While the active trading pattern in wheel trading is a riskier strategy, similar to leverage trading, a successful wheel strategy has the potential to generate additional profits from premiums. This makes it one to consider for experienced traders who wish to explore trading systems beyond buy and hodl.

Both systems can be used in combination; however, wheel options trades end in the purchase of an asset at a discount, and the purchased asset is held until it reaches even more profitable levels. Buying and holding is a safer route for investors yet to understand the principles of options trading.

Both systems come with their own risk and choosing one over the other might boil down to the preferences of the trader alone.

Final Thoughts

There are an unlimited number of trading strategies in an attempt to mitigate the risks of losing out on our investments or at least generating consistent profit, especially in a volatile market like crypto. The wheel options strategy is an example of an approach to asset trading that prioritizes risk mitigations. 

Before undertaking any trading strategy, remember to consider the associated risks. 

Do note also that this content is purely educational and no part was meant as financial advice. As a standard, perform personal research before investing or trading cryptocurrencies and apply caution while interacting with trading systems.

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Joel Agbo
Joel Agbo
Joel is deeply interested in the technologies behind cryptocurrencies and blockchain networks. In his over 7 years of involvement in the space, he helps startups build a stronger internet presence through written content. Follow the author on Twitter @agboifesinachi

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