Bonus Topic: The Wheel Trade

A few weeks ago a friend I was coaching on options trading asked me what a wheel strategy is.

As a bonus topic for this week we will explain how the wheel strategy functions and give an example of an actual wheel trade we did several years ago when Project Hedgehog was in its infancy.

The wheel strategy is a systematic, income-generating approach designed to capitalize on time decay of option premiums. This strategy leverages both call and put options which we covered in detail beginning in Lesson 5 and continuing from there.

The wheel process begins with selling cash-secured put options on a stock (or ETF, REIT, etc.) that the trader is comfortable owning. This is simply a short put position, and the “cash-secured” label means that your broker sets aside cash in your account to pay for the stock at the strike price in case the trader is forced to by it.

By selling these puts, the trader collects an immediate premium (income) in exchange for the obligation to buy the shares at a specific strike price if the stock falls below that level. In an ideal scenario, the stock stays above the strike, the option expires worthless, and the trader simply keeps the premium. The process can then be repeated, effectively getting paid to wait for a better entry point.

If the stock price drops and the trader is "assigned" the shares, the second phase of the wheel begins: selling covered calls. Now that the trader owns the underlying stock, they sell call options against their position to collect further premiums. This creates a dual-layered profit potential: the trader earns income from the call premiums while also benefiting from any capital appreciation up to the call's strike price. If the stock eventually rises above the call strike, the shares are sold (called away) at a profit, the trader is left with cash, and the cycle resets back to the first step of selling puts.

We will walk through all parts of this cycle in the specific example of a real trade we entered 2015.

On 2/11/2015 PepsiCo (PEP) was trading at $97.84/share and we decided to enter a wheel trade. By selecting this stock we hoped to collect option premiums as is typically for this type of trade.

Also, since PEP is a regular quarterly dividend-paying stock we also had the opportunity to potentially capture a random dividend if we happened to own the stock across an ex dividend date.

Step One: We kicked off the trade by selling the $97.50-strike put option expiring on 3/20/2015 for $2.11 per share ($211 per contract). This short put gave us the obligation to buy the stock at $97.50 should it fall below that price before the contract expired.

The “cash-secured” aspect of this trade means that our broker sets aside $9,750 per contract in our our account because each put contract represents 100 shares of stock. This means that if the stock were to fall below $97.50, we will have the funds available in the account to make that stock purchase.

We got to keep the premium of $2.11, however, no matter what happened with the stock price. This premium is the point of the wheel trade.

Step Two: On 3/20 the stock had fallen to $94.10 and we were assigned the stock. This represented a loss for us because we were forced (through the put option) to buy the stock for $97.50 per share when the market price was far below that.

At that point, we were holding 100 shares of the stock per contract we sold. We moved on to the next phase of the wheel strategy by selling a call option.

On 3/23 we decided to sell the $97.50-strike call option expiring on 4/24/2015 for $1.08. This means that we took on the obligation to sell the stock at $97.50 (the exact same price at which we bought it) and we got to the the $1.08 premium no matter what happened.

Step Three: On 4/24, PEP was trading at $95.73. This was below the strike price of $97.50 on our short call option, so the option expired worthless and we kept both the stock itself and the $1.08 premium we collected for selling the option originally.

On 4/27, we sold the next month’s call option at the $97.50 strike expiring on 5/29/2015 for $.81 and our wheel trade continued to roll!

Step Four: On 5/29, PEP was trading at $97.06, so once again our short call option expired worthless. We pocketed the $.81 per share premium and move on to the next call option.

On 6/1 after the previous option cleared, we sold the next month’s call option at the $97.50-strike expiring on 7/2/2015 for $1.33

We also during the month of June got a nice benefit of collecting a quarterly dividend of $.70 as we still actually owned the stock on the ex dividend date of 6/3/2015. We hoped this might happen to us!

We can start to see how this strategy works. The stock price fluctuates up and down as time passes, but we consistently bring in premium every month from our option trades.

Step Five: On 7/2, PEP was trading at $94.50 so once again our current short call option expired worthless. We kept the wheel rolling by selling the $97.50-strike call expiring on 8/7/2015 for $.71

Step Six: On 8/7, PEP shot up to over $99 per share, forcing us to sell via our short call position at $97.50

We no longer owned the stock or any options at this point. We sold the stock for the same price we bought it ($97.50), and the options premiums and dividend we collected amounted to a profit of $6.74 per share (or $674 per contract).

On a cost basis of $97.50 per share this represented a profit of 6.9% in roughly five months!

We had to make the choice of walking away from the trade or starting the wheel over by selling a put option below the stock’s current price. We decided to keep going and we sold the $97.50-strike put option expiring 9/11/2015 for $1.05

Step Seven: On 9/11, PEP was trading at $91 per share. This means that our short put option forced us to but the buy the stock again at $97.50 exactly as we did way back on 3/20.

On 9/14, we sold the next $97.50-strike call option expiring on 10/16/2015 for $.30.

Step Eight: On 10/16, PEP was trading above $98 per share by the end of the day and our stock was called away via our short call option for $97.50. Again, this was the same price at which we bought the stock.

On 10/19 we no longer owned the stock or any options so we decided to keep the wheel strategy alive by selling the next put option. We sold the $97.50-strike put option expiring 11/20 for $.78

Step Nine: On 11/20, PEP was trading over $100 per share. Our short put option expired worthless.

On 11/23, we sold the next $97.50-strike put option expiring on 12/18 for $.88

Step Ten: On 12/18, PEP was still trading at over $100 per share, so our short put option expired again.

On 12/21, we sold the next $97.50-strike put option expiring on 1/15/2016 for $1.26.

Step Eleven: Happy New Year! On 1/15, PEP was trading at $96 per share. Once again, this forced us to buy the stock at $97.50 through the obligation of our short put option.

We own the stock again now for the third time! As stock owners, we pivoted back to selling the $97.50-strike call option expiring on 2/19/2016 for $.93

Step Twelve: On 2/19, PEP had risen to above $99 per share again. This forced us to sell our stock at $97.50 because of our obligation from our short call option.

We were left again with no stock and no current options contracts. At this point we could have continued the trade by simply selling another put option, but we decided we had played around long enough and we walked away with our profits.

The Results: So how much money did we make? Well, we made no money on the stock at all. Every time we bought or sold the stock via the obligations of our options contracts, the price was always $97.50 per share. As a result, our profits were solely comprised of the option premiums and the single dividend payout in June.

We collected a total of $11.24 per share in options premiums. We also picked up a single dividend payout of $.70 for owning the stock across an ex dividend date. Our total profit was $11.94 per share.

We essentially had $97.50 per share ($9,750 per contact) tied up for the duration of this trade. We either had a cash-secured put (consuming $97.50 per share), or actually owned the stock at a cost basis of $97.50 a share.

This means that in the one year we traded these positions we made a profit of 12.2% ($11.94 / $97.50).

We do not use wheel trades specifically in Project Hedgehog. As we learned in Lesson 5 through Lesson 8, covered call and short put strategies both have unlimited risk to the downside which places them outside the Core Principles of Project Hedgehog.

We did well in our PEP trade, but at any time a sharp downward move in the stock price would have caused a significant loss and it would be very difficult to manage the position profitably going forward from that point.

If you have any questions about the wheel strategy or anything else, please reach out to us:

[email protected]

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