Thoughts on using an option wheel strategy with a hedge?

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Lemur
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Thoughts on using an option wheel strategy with a hedge?

Post by Lemur »

If you're aware of this option strategy, then you know a typical option wheel strategy works like this:

1.) Sell a cash-covered PUT on a stock (collect premium).
2.) Get assigned 100 shares per contract eventually.
3.) Sell a covered CALL on the same stock. Ideally above the purchase price in step 2.
4.) Get shares called away eventually. Hopefully at a profit (one trades away any gains that occur above the contract price).

I discussed this one on the forum here looking for feedback when I had initially thought it would be brilliant to use a SWR replacement...
viewtopic.php?f=3&t=11230

Turns out it wasn't all that brilliant (and the strategy has some downsides). In essence:

PRO: Consistent profit as long as the stock trades flat or keeps slowly trending up; great to use in a high IV market. Great to use for stocks that bounce around in a tight range.

CON: One could end up bag-holding if the stock keeps trending down.


I thought about a modifier on the above strategy that could work pretty well for consistent profits and also protects from the downside...

Same strategy but with a modification...

1.) Sell a cash-covered PUT on a stock (collect premium).
2.) Eventually get assigned 100 shares of stock per contract.
3.) After assignment, immediately purchase an ATM (at-the-money) PUT on the stock expiring a few months out.
4.) Sell weekly or bi-weekly covered CALLS on the same stock.
5.) But instead of having shares called away if the stock price rises, one should roll-out and close the covered call positions at about 50% profit or so. For instance, if you collect a $200 premium in step 4 and the stock price rises, you could buy to close the position for say $100 (net profit $100). Repeat as necessary.

The benefit of the above modification is that you're insured against a sudden drop in the stock (which maybe Coronavirus second WAVE could cause ...that is a different topic).

Can anyone think of drawbacks with above? I can think of two....

Drawbacks:

1.) If the stock trends downward, one will risk losses on both the puts and the calls that may exceed the profit on the stock if the stock suddenly rises.

2.) You must profit enough off the premiums to exceed the cost of the put purchased in step 3 to profit. At worst one might do a lot of trading to only end up with free or cheap insurance. At best, profits can be had. In each case, gains will be traded away if one was just better off buying the stock with dollar cost averaging.

Any other thoughts certainly welcomed.
Last edited by Lemur on Tue Jun 30, 2020 10:57 pm, edited 1 time in total.

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Lemur
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Re: Thoughts on using an option wheel strategy with a hedge?

Post by Lemur »

Some definitions of rolling options:

https://www.fidelity.com/learning-cente ... ered-calls

Step 5 reads subjectively depending on what the stock does. Essentially, you want to 1.) Avoid Assignment (shares called away. 2.) Roll down options at 50% profits if stock price falls or 3.) Roll out options if stock price rises.

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Re: Thoughts on using an option wheel strategy with a hedge?

Post by jacob »

You're beginning to approximate put-call parity which consequentially will provide a market interest rate because your de facto exposure is that of a bond (all your greeks are small). IOW, you're building a bond synthetically out of options and equity. Your profit in this case will come from vig which given the low commissions might just be possible insofar your predictions are good enough to stay on the maker (passive) side. If not, you're the one paying the vig.

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Lemur
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Re: Thoughts on using an option wheel strategy with a hedge?

Post by Lemur »

@Jacob

Thanks for these sources. I'll read through them.

I'm wondering if that put-call parity explains the phenomenon I found yesterday looking at PEPSI CALL/PUT prices. When I priced the PEPSI 135 PUT expiring Oct 18, it came out to $7.10 or $710 total price. If one would sell weekly $135-$140 CALLS up to the Oct 18 date, it would net you just about $700-$750 dollars give or take (I used the last close prices for that projection).

Lucky C
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Re: Thoughts on using an option wheel strategy with a hedge?

Post by Lucky C »

Lemur wrote:
Tue Jun 30, 2020 9:25 pm
CON: One could end up bag-holding if the stock keeps trending down.
Sounds like a strategy that will work well in a long-term bull market and/or a market without short-term euphoric sentiment, and work poorly in a long-term bear market and/or a market with short-term euphoric sentiment.

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