Is now the time to start bottom-feeding?
Surely there are some good “buys” at these levels?
These are just two of the many questions I’m hearing right now, from the talking heads to readers of this daily. So, for those of you asking this question and just receiving a simple “yes” in return, well, I think I might have a better alternative to consider—it’s more of a treading-lightly approach. It’s called a wheel options strategy.
What is a Wheel Options Strategy?
The wheel strategy is an inherently bullish, mechanical options income strategy known by various names. The covered call wheel strategy, the income cycle, and the options wheel strategy are just a few of the many names that investors use. But one thing is certain: The systematic approach remains the same.
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More and more investors are choosing to use the wheel options strategy over a buy and hold approach because of the ability to create a steady stream of income on stocks you want to or already own.
The mechanics are simple.
- Sell Cash-Secured Puts on a stock until you are assigned shares (100 shares for every put sold)
- Sell Covered Calls on the assigned stock until the shares are called away
- Repeat the Process!
Basically, find a highly liquid stock that you are bullish on and have no problem holding over the long term. Once you find a stock that you’re comfortable holding, sell out-of-the-money puts at the price where you don’t mind owning the stock.
Keep selling puts, collecting even more premium, until eventually you are assigned shares of the stock, at the strike price of your choice. Once you have shares of the stock in your possession begin the process of selling calls against your newly issued shares. Basically, you are just following a covered call strategy, collecting more and more premium until the stock pushes above your call strike at expiration. Once that occurs, your stock will be called away, thereby locking in any capital gains plus the credit you’ve collected.
No one can call a bottom, or top for that matter. But we can use probabilities to our advantage and collect premium while doing so to lower the cost basis of a stock that we eventually want to own, again, at the price of our choosing.
By selling puts, you are able to produce a steady stream of premium that can be used as a potential source of income or to simply lower your cost basis on the position.
I take this approach every time I wish to purchase a stock or ETF, regardless of if I am “bottom-feeding” or not. And oftentimes, once I am put shares of the stock, I simply sell covered calls against my newly acquired shares and use the wheel approach going forward.
Trying the Wheel Strategy on PayPal
So, let’s say we are interested in buying PayPal (PYPL), but not at the current price of 88.58.
You prefer to buy PYPL for 72.50.
Now, most investors would simply set a buy limit at 72.5 and move on, right? But that approach is archaic. Because you can sell one put for every 100 shares of PYPL and essentially create your own return on capital (depending on the strike you choose).
Some say it’s like creating your own dividend and, in a way, I kind of agree.
A short put, or selling puts, is a bullish options strategy with undefined risk and limited profit potential. Short puts have the same risk and reward as a covered call. Shorting or selling a put means you are promising to buy a stock at the put strike of your choice. In our example, that’s the 72.5 strike.
If you look at the options chains for PYPL below you will quickly notice that for every 100 PYPL shares we want to purchase at 72.50, we are able to bring in roughly $1.50, or $150 per put contract sold, every 39 days.
The trade itself is simple: Sell to open PYPL July 15, 2022, 72.5 puts for a limit price of $1.50.
By selling the 72.5 put options in July, you can bring in $150 per put contract, for a return of 2.1% on a cash-secured basis over 39 days. That’s potentially $1,350, or 18.6% annually, per contract. You can use the premium collected from selling the 72.5 puts either as a source of income or to lower your cost basis.
Just think about that for a second.
You want to buy PYPL at 72.50. It’s currently trading for roughly 88.58. By selling cash-secured puts at the 72.5 strike for $1.50 you can lower your cost basis to 71. That’s 22.1% below where the stock is currently trading. And you can continue to sell cash-secured puts on PYPL over and over, lowering your cost basis even further until your price target is hit.
Or, like most investors, you could just sit idly by and wait for PYPL to hit your target price of 72.50–losing out on all that opportunity cost and the inflated premium that can help to provide a decent source of consistent income.
In review, by selling cash-secured puts at the 72.50 strike we receive $150 in cash. The maximum profit is the $150 per put contract sold. The maximum risk is that the short 72.5 put is assigned and you have to buy the stock for 72.50 per share. But you still get to keep $150 collected at the start of the trade, so the actual cost basis of the PYPL position is $72.5 – $1.50 = $71 per share. The 71 per share mark is our breakeven point. A move below that level and the position would begin to take a loss.
But remember: most investors would have purchased the stock at its current price, unaware there was a better way to buy a security. We rarely take that approach. We know better. We understand we can purchase stocks at our own desired price and collect cash until our price target is hit. It’s a no-brainer.