Wheel Option Strategy
WHAT ARE THE CHARACTERISTICS OF THIS OPTION STRATEGY?
The wheel option strategy is a type of option spread that involves buying and selling option contracts of different strike prices on the same expiration date. The wheel strategy is most often used to take advantage of changing volatility, or to make a directional play. When used to make a directional play, the wheel strategy is much less risky than a simple long or short option trade. Because the wheel strategy involves buying and selling options of different strike prices, it’s a great way to manage your risk while taking advantage of different price movements.
IS THIS A BULLISH, BEARISH OR NEUTRAL STRATEGY?
The wheel option strategy can be used for both bullish and bearish strategies. For a bullish strategy, long calls and short puts are used. For a bearish strategy, long puts and short calls are used. The wheel option strategy can also be used as a neutral strategy, with long calls and long puts combined to form a wheel.
IS THIS A BEGINNER OR AN ADVANCED OPTION STRATEGY?
The wheel option strategy can be used by both beginners and advanced traders. The strategy does require traders to be comfortable buying and selling options on the same underlying asset at the same expiration date. While the wheel strategy itself is relatively straightforward, it can take a bit of practice to become comfortable with the strategy and understand the different risks and rewards associated with it.
IN WHAT SITUATION WILL I USE THIS STRATEGY?
The wheel option strategy is often used when market makers expect the price of the underlying security to remain relatively range-bound or when the market makers expect the price to move in a particular direction. By combining options contracts at different strike prices, the wheel strategy allows traders to take advantage of both volatility and any directional movement in a stock.
WHERE DOES THIS STRATEGY TYPICALLY FALL IN THE RANGE OF RISK-REWARD AND PROBABILITY OF PROFIT?
The wheel option strategy typically has a lower risk (or in some cases even a higher reward potential) when compared to a single long or short option position, depending on the strike prices used. The probability of profit (POP) for the wheel strategy is often higher than for a single long or short option, as the trader is looking to capitalize on both volatility and direction in the underlying security. However, the POP will depend on the strikes and amount of premium used in the wheel trade.
HOW IS THIS STRATEGY AFFECTED BY THE GREEKS?
The wheel option strategy is affected by several greeks, including theta (time decay), vega (volatility), gamma (sensitivity to underlying price), delta (sensitivity to underlying price), and rho (sensitivity to interest rates). The wheel strategy’s payoff is affected largely by underlying price-action, and if the wheel consists of long and short options with different strike prices, it will also be affected by changes in volatility.
IN WHAT VOLATILITY REGIME (I.E. VIX LEVEL) WOULD THIS STRATEGY BE OPTIMAL?
The wheel option strategy is most optimal in a moderate volatility regime, or when the VIX level is between 15 and 50. A high VIX level or extreme volatility can make it difficult to enter and exit wheel trades in a profitable manner. Additionally, a low VIX level or stagnant market conditions can make it difficult for the wheel strategy to reap profits.
HOW DO I ADJUST THIS STRATEGY WHEN THE TRADE GOES AGAINST ME? AND HOW EASY OR DIFFICULT IS THIS STRATEGY TO ADJUST?
When the wheel trade goes against you, you can adjust the wheel to reduce your risk or improve your potential reward. Generally, the wheel strategy is easy to adjust as you can close out one side of the wheel and replace it with another option contract of different strike prices, expiration date, etc. You also have the flexibility to roll up or roll down the wheel depending on the market conditions.
WHERE DOES THIS STRATEGY TYPICALLY FALL IN THE RANGE OF COMMISSIONS AND FEES?
The wheel option strategy typically requires higher commissions and fees than a single long or short option trade, as the wheel strategy involves buying and selling multiple option contracts. However, the commissions and fees can vary depending on the broker, the underlying security and the strike prices used in the wheel.
IS THIS A GOOD OPTION INCOME STRATEGY?
The wheel option strategy can be a good option income strategy as it involves buying and selling options with different strike prices while still managing risk. By utilizing the wheel strategy, a trader is able to mitigate risk while still having the potential to realize profits from both volatility changes and directional movement in the underlying security.
HOW DO I KNOW WHEN TO EXIT THIS STRATEGY?
Traders should always have an exit strategy when trading options. When utilizing the wheel option strategy, traders should set exits based on the amount of risk they are willing to accept, or based on their time horizon. For example, a trader may decide to exit the wheel trade when the underlying stock price reaches the lower strike of the short option in the wheel, indicating an imminent move to the downside.
HOW WILL MARKET MAKERS RESPOND TO THIS TRADE BEING OPENED?
Market makers may respond differently to the wheel option strategy being opened, depending on the underlying security, strike prices and expirations used in the wheel. Generally, market makers are likely to become concerned when the wheel trades involves a wide range of strike prices, as they may believe the trader is attempting to front-run an expected volatility move.
WHAT IS AN EXAMPLE (WITH CALCULATIONS) OF THIS STRATEGY?
Let’s look at a simple example of a wheel option strategy. Assume that AAPL is trading at $105 and you believe the stock will remain relatively range-bound over the next month. You enter a wheel trade with the following option contracts:
-Long 1 Call (Strike 107)
-Long 1 Put (Strike 103)
-Short 1 Call (Strike 109)
-Short 1 Put (Strike 101)
If AAPL is trading at $105 at expiration, the long calls will be worth zero and the long puts will be worth $2.00 each (-105 + 103 = 2). The short calls and short puts will be worth zero as well, resulting in a net credit of $2.00 ($2 x 2 = 4).
HOW CAN MARKETXLS HELP?
Here are some templates that you can use to create your own models
Search for all Templates here: https://marketxls.com/templates/
Relevant blogs that you can read to learn more about the topic
Maximizing Returns with Covered Put Options
The Wheel Strategy For Options (Explained With Example)