Section 1: How options work.
There are two types of options, CALLS and PUTS. I am going to use Gamestop at $50 a share to use as and example to explain how these work.
If you BUY a CALL you have the right to buy 100 shares of the stock at a certain price (the strike price) by a set time which is determined by the expiration date. You are not required to actually buy the stock, only if you want to.
Example: A $40 Gamestop call with expiration of 2/26.
The value of the call is determined by:
Intrinsic value (= stock price – strike price). In the case above strike is $40 the intrinsic value would be $50-$40=$10 per share. Options only have intrinsic value if they are IN THE MONEY meaning the strike price is lower than the stock price
Time value – the time value is determined by the amount of time you have before option expires
Price of stock. The higher the stock goes to with everything else being equal all options go up in price
Volatility – which is to say how much the stock moves per day. If gamestock were only moving an average of $1 a day it would have very little time/volatility value. If it moves $10 per day it will have a lot more. If you have shares that are OUT OF THE MONEY (which means the strike price is higher than stock price) the volatility/time value can go up or down very quickly.
Required funds/margin. Buying a call requires no margin. It only requires you pay the price to buy the option. The most you can loose is your initial investment if you do not utilize the option before the expiration date in which case the option expires worthless. 90 percent of call options expire worthlesst.
If you SELL a CALL: you are OBLIGATED to sell 100 shares of stock at the strike price IF the buyer decides to buy the stock.
Required funds to sell, none you actually get money. Margin required: you have to have 100 shares of the stock to cover the call in case you have to sell the shares. In most accounts you can only sell calls if they are covered with shares. This is called a COVERED CALL.
In this case one of two things will happen:
The option will expire worthless if the stock finishes at the day of expiration at or below the strike price. If this happens the premium you got for selling the option you GET TO KEEP FOR FREE!
You will be force to sell you shares at the strike price. In the case above (which would NOT be recommended for selling a covered call) you would have to sell your 100 shares of gamestop for $40. Please note if you have to sell the shares you STILL get to keep the premium you got for selling the call.
If you BUY a PUT: you have the right to SELL 100 shares of the stock for the strike price. You are not required to, you get to choose. So if you buy a $40 put you can sell your shares of gamestop for $40 no matter what the price of the stock is.
There is no margin to BUY a PUT just need the money of the cost of the PUT. The max you can loose is the price you paid for the PUT. 90 percent of all puts expire worthless!!!
The value of the PUT is the same as a call except that the intrinsic value = strike price – stock price and the value of the PUT goes up as the stock goes down.
If you SELL a PUT****: you are obligated to BUY 100 shares of the stock at the strike price. Basically you are putting in a limit order to buy, AND GETTING PAID TO DO SO!!! For the above example I would have to buy the 100 shares of Gamestop at $40 per share that the buyer of the PUT is selling.
If you sell a put that has a lower strike price than the stock price the following could happen:
Stock price goes up and the value of the put crashes.
Stock goes nowhere in price and the time value slowly goes away, PUT expires worthless.
Stock goes DOWN, but not enough for the stock to get to be lower in price than your strike price
Stock goes DOWN a LOT and so at expiration the stock is lower in price than the strike price.
If 1,2, or 3 happens the option expires worthless. YOU GET TO KEEP THE PREMIUM YOU COLLECTED FOR SELLNG THE PUT. FREE MONEY!
If 4 happens you buy 100 shares of the stock at the strike price.
No money is require to sell the stock. HOWEVER, a lot of margin is required. You must have money in your account (after you collect the money for selling the option) equal to 100 time the strike price (i.e. enough money to buy those 100 shares at the strike price). In the case above for the $40 put for each put you sell you must have 40*100=$4000 in account. If you sell the option for $5 per share ($500 for the contract as 5*100=500) you will have to have $3500 of your own money in the account that you will not be able to do anything else with as long as you are short the put.
Section 2: How the wheel works.
Now that you understand how options work now lets go over the steps for the wheel:
Step 1: Find a stock that you would like to own if the price was low enough.
Find a stock you believe in for short term and long term. It is better if you use a stock that is also volatile because the option prices will be high and you make better returns (so you don’t want to do this with dividend stocks that have very low volatility).
Step 2: Determine the price you would be happy buying it. You will want a price as close to possible to the current price. The further in price you set away from the current price the less likely you will be to end up with shares HOWEVER you will also get a lot less money. Note that as you get away from current price the price of the options decrease at an EXPONETIAL RATE. I recommend using a price 10-30% below current stock price unless you are selling one day before expiration. You want a price you don’t think it will actually get to by expiration but want to be as close to that as possible.
Step 3: Determine the timeframe. You will want to pick expiration of a few weeks but you may find that one week is best sometimes you may need 2-3 weeks. The point is you want that time value to drop as FAST as possible.
Step 4: Sell the puts. Collect that premium. You can choose your risk tolerance and how fast you want to profit. I would recommend that the price of the option should be at least 1% of the strike price because then your profit will be 1%.
Step 5 (optional): If the price of the option falls by 90% then buy back the put. No need to hold it to expiration to get that last drop of profit. You will make more money by selling a new put. If you use this step after step 5 return back to STEP 1.
Step 6 (if you do not do step 5): Option expires worthless. Book your profits in your journal. Congrats! No, go back to STEP 1, rinse and repeat. You can do the same stock, or do a new one.
Step 7 (if neither step 5 or 6 occur, this is aka the worst case scenario, sort of): This step occurs if and only if the price of the stock actually falls below your strike price and you were forced to buy the stock. Oh no, the horror, the horror.
Never fear now we flip to the other half of the WHEEL. Now we go from selling PUTs to selling CALLs.
FUN FACT: It is very possible I actually just bought the stock for effectively a LOWER price than if I had just waited and bought it. Lets say in our example above I sold $40 gamestop puts and gamestop drops to $39. I buy a $39 stock for $40 BUT lets say I sold the options for $3 a share. In this case my actual effective price of the stock is actually only $37 because I was paid $3 to buy it for $40. I effectively bought it for less than current price. I am oddly enough still ahead in this trade so far. As long as gamestop does not fall to under $37 I am still in the green.
Step 8: Decide how much you think the stock will go up in that week. The goal here is to actually sell the stock using the calls and getting those premiums and get paid for each week that you don’t sell. We are going to be usually 10% or less above stock price so we can get even higher premiums that we did when we were selling puts.
NOTE: your strike price for calls should be AT OR ABOVE what you bought the stock for so that you don’t loose money. It is okay if it takes a few weeks or even a few months to get it back to your buy price. If you don’t think the stock can do that, you should not have sold those puts in the first place. This is why we have to pick a stock we believe in.
Step 9 (optional): If the call you sold decreases in value by more than 90% you can buy it back then sell another option for a later out expiration or maybe at a lower strike price. Return to STEP 8
Step 10 (If step 9 does not occur): option expires worthless. You get to keep that sweet premium for FREE. Return to STEP 8
Step 11: FINAL STEP
If the stock finishes at or above your strike price you will be forced to sell the stock at the strike price, oh darn.
Fun fact: If I bought Gamestop at $40 as example above and decided it would go to $60 and sold a $60 call for say $3 and the stock went to $61 I actually make MORE money by using the call to sell it. Yes I just sold the $61 stock for $60 but I was paid $3 to do it so I actually effectively sold the stock for $63! More green for me!
Once you finish with Step 11 guess what, you are going to go ALL THE WAY TO STEP 1 and do the wheel again!