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What Is The Wheel Strategy in Crypto Trading?

2023-11-27 02:15:59

What Is the Options Wheel Strategy?

The "wheel options strategy," or simply "the wheel," leverages the fundamentals of options contract trading to create a systematic approach to investing that aims to mitigate risks. It's a twist on the classic investment mantra of "buy low, sell high," tailored for options trading with an added emphasis on risk management and asset accumulation.

The strategy revolves around methodically using options contracts to potentially purchase stocks at reduced prices and to generate income through premiums. This approach incorporates essential elements such as contract duration, option pricing, and resale opportunities. While originating in the traditional stock market, the wheel strategy has found its place in the cryptocurrency arena as a viable trading tool.

What Is a Cash-Secured Put?

A cash-secured put is the initial step in the wheel strategy. It involves an investor selling a put option while simultaneously setting aside the cash needed to buy the underlying asset if it falls to the option's strike price. This strategy is typically employed by investors who have a neutral to slightly bullish outlook on the asset and are comfortable owning it at a lower price. The premium collected from selling the put option serves as income or a discount on the asset if the investor is assigned to purchase it.

What Is a Covered Call?

The subsequent phase in the wheel strategy involves writing a covered call. In this strategy, an investor holds an existing long position in an asset and sells call options on the same asset to earn premium income. This strategy is best suited for investors with a neutral stance on the asset's short-term price movement, as it allows them to profit from the premium and potentially from the asset's appreciation, up to the strike price of the call options sold. If the asset's price rises above the strike price, the asset may be called away, but the investor benefits from the sale proceeds at the strike price.

Cash Secured Put vs Covered Call

Cash-secured puts and covered calls are both conservative options trading strategies that allow investors to generate income but cater to different market sentiments and positions regarding the underlying asset.

Cash Secured Put

In the cash-secured put strategy, you sell a put option on a security you are willing to own, and you set aside the cash needed to buy the security if the option is exercised. This is a suitable strategy if you are neutral to bullish on the security and would be comfortable purchasing it at a lower price.

Advantages: It provides income through premiums and allows you to potentially buy the security at a discount.

Disadvantages: The risk is if the security's price falls significantly, you must buy it at the strike price, which could result in a loss if the security's price continues to decline.

Covered Call

A covered call strategy involves owning the underlying security and selling a call option on it. It's appropriate if you are neutral to bearish on the security's short-term prospects and are prepared to sell it if the price rises to the call's strike price.

Advantages: It provides income through premiums and can offer additional profit if the security's price increases up to the strike price of the call.

Disadvantages: The potential downside is that you might miss out on further gains if the security's price rises above the strike price, as you're obligated to sell. Additionally, if the security's price drops sharply, the premium earned may not compensate for the capital loss on the security itself.

How to Trade the Wheel Strategy

The wheel strategy is a disciplined approach to options trading that involves a continuous cycle of selling options, potentially taking ownership of the underlying asset, and then selling options again. Here's how to navigate this strategy:

  1. Begin by selling a cash-secured put option on an asset you would like to own, collecting a premium upfront.
  2. If the asset's price falls below the strike price, you may be assigned to purchase the asset at the strike price. If the asset's price remains above the strike price at expiration, the put option expires worthless, and you keep the premium.
  3. If you acquire the asset through assignment, proceed to sell a covered call option, earning another premium.
  4. If the asset's price rises above the strike price of the call, you may have to sell the asset at the strike price. If the asset's price stays below the strike price at expiration, the call option expires worthless, and you retain the premium.
  5. After the call option is assigned or expires, the cycle starts over with selling another cash-secured put.

It's crucial to carefully select the underlying asset, strike prices, and understand market conditions before engaging in the wheel strategy. Adequate knowledge of options trading and sound risk management practices are essential for success with this strategy.

Considerations Before Using the Wheel Strategy

The wheel strategy offers multiple potential benefits, allowing you to earn premiums or acquire assets at a discount. However, there are several considerations:

  • Purchasing assets at a discount may still result in an unrealized loss if the asset's value decreases further.
  • The premiums for out-of-the-money options tend to be lower, which may necessitate multiple trades, increasing exposure to risk over time.
  • Choosing inappropriate strike prices can lead to net losses, especially if the asset's price moves significantly.

Before employing the wheel strategy, consider the following:

  • Understand the risks associated with each step of the strategy.
  • Assess the volatility and liquidity of the underlying asset.
  • Use thorough analysis to select strike prices and expiration dates.
  • Be prepared for the obligation to buy or sell the asset if the options are assigned.
  • Consider the impact of transaction costs on overall profitability.

The Size of Your Account

When engaging in the wheel strategy with options trading, the size of your trading account is crucial. Each option contract represents 100 units of the underlying asset, such as Tesla shares (TSLA) or Ethereum (ETH). Therefore, ensure that your account balance is at least 100 times the value of the asset you intend to trade. This buffer is necessary to cover the potential obligation to purchase the underlying asset if the put option is assigned.

The Asset to be Traded

The selection of the asset is vital, especially if your account cannot support large-scale trading. It's essential to choose an asset whose price behavior you understand well and that aligns with your account size. Consider trading an asset with a price that is manageable for your account and ensure you have a strong grasp of its price patterns before initiating trades.

The Contract Validity Period

The expiration period of your options contract is a critical decision. A longer duration may allow for more significant price movements, giving the asset more time to reach desired price points. However, for volatile assets like cryptocurrencies, a shorter expiration could be strategic to capitalize on quick movements, albeit at potentially lower premiums.

The Premium Charged

Setting an appropriate premium is a balancing act. Your premium should be sufficient to offset potential losses, yield a reasonable profit, and still be attractive enough not to deter potential buyers. The premium should be competitive and reflect market conditions, factoring in variables like the Option Greeks, which influence option pricing.

Risk Management Provisions

Risk management is integral to the wheel strategy. You need to have adequate cash reserves for cash-secured puts and a planned approach for holding a long position in covered calls. Define your profit goals, time horizon for the strategy, and your capacity to tolerate unrealized losses. Understanding the risks inherent to options trading and having strategies to mitigate them is crucial for success.

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