A second look at the wheel strategy

We all love the wheel, but are we getting the most out of it? This recording addresses some of the most common misconceptions that get in the way of huge gains.

____________________

Transcript:

Hey guys, it’s Mikey Millions, and in this video we are going to relook the Wheel strategy, and talk about some of the points that could probably use some refinement.

About 18 months ago, I made a video on the wheel, and to this day it’s still the strategy I get the most questions about. And that makes me happy because even though I use the wheel less than I used to, I still love this strategy. It’s a great way to learn, it’s easy to manage, and you seriously can make stacks of cash with it. If you hang out in our Discord, you’ll see people posting their wheel gains all the time.

But I’ve also seen people totally screw this up and either box themselves into a stock they don’t want, or they’ll overestimate their gains. In this video, we will set the record straight by addressing a handful of common misconceptions, and hopefully get everyone on track.

#1: The absolute most common problem I see, is people entering the wheel based just on premiums offered, with no regard for their opinion on the stock. If you’re asking the question, “What are your favorite stocks to wheel,” then you’re already in trouble. When you look to enter a wheel, your first priority should be to find a stock that you like, and you want to own. Quite often, you are going to sell a cash-covered AKA cash-secured put to enter the wheel, and the stock is going to tank. And you’re going to be stuck holding it. If you like the stock and you want it in your portfolio, this is no problem for you. You can just sell the covered call way up at your assignment price, and collect whatever meager premium it offers. Since you want to own the shares anyway, you are totally fine with playing the long game and pulling some change for reinvestment in the meantime.

But what happens when you sell a put on some stock you don’t care about just to collect big chungus premiums at earnings, and now you’re stuck holding 10,000 shares of GRPN. If you don’t want GRPN, it’s going to kill you inside having to watch the stock slowly melt off week after week while you collect pennies in covered calls. You’re going to end up hating this position and selling it for a loss, or selling a covered call below your basis and getting assigned for a loss.

Instead of asking, “what are your favorite stocks to wheel,” ask “what is your favorite stock.” Then once you spot something, ask yourself, “if I get assigned and the stock drops another 10%, will I get an ulcer?” If the answer is yes, then this is not a stock for you to wheel, no matter how tasty the premium looks. When someone asks you why you’re wheeling, you should be able to say, “I like the stock.”

#2: Right along with that point, we see the Wheel Trap. I call it this because people find a nice, volatile stock, and they start eyeing those ATM weekly premiums- a sweet 4%/week yield. Then they think, if I do this every week, that’ll be $69,420/year, and I can just keep going at it until I can afford a cybertruck.

It’s a nice thought. But here is the problem: There is no way in hell you are wheeling ATM strikes over into perpetuity. I get it, you want to sell that high extrinsic value and pocket the money. That’s awesome. But remember that you don’t get assigned unless the stock drops. And if it does, then you can no longer sell ATM strikes without taking a loss on the shares. For example, you sell a put at the $20 strike and receive $0.50 premium. Cool. Stock drops to $19. You are now $0.50 below your basis. If you sell the ATM strike at $19 to collect another $0.50, then you are committing to selling your shares a full dollar below where you bought it. That $0.50 gain from selling each the call and put did nothing. If you choose to sell at your $19.50 basis, then you won’t receive $0.50 premium. Maybe $0.30. And if you feel the need to sell right where you got assigned at $20, then you’re now collecting $0.15 premium. Your thesis of peddling ATM strikes week after week goes away, and now you’re collecting less than half the premium you thought you would.

This can also go the other way too. If you sell a put at $20 for $0.50 premium and the stock goes to $21, then you made $50, and your buying power now allows you to sell a put at $20.50. But now you’re selling an OTM put instead of an ATM put, and you’re collecting much less premium. Again, your plan of selling ATM strikes each week is blown, since you don’t have the collateral to sell the $21 strike this week.

The only way this works, is if the stock stays volatile, but ends up expiring right near your strike each week. It’s not realistic. And if it did move that predictably, you’d be much better off with a short straddle anyway.

Instead of planning your strikes based on the yield of ATM strikes, select your short put based on the strike you truly want to buy at, and collect your premium while you wait to get assigned. Then, sell the covered call at a strike you’re okay selling at, and repeat. Don’t get caught chasing yield and being disappointed when you’re stuck trying to wheel a stock that just keeps moving in the same direction.

#3: Double counting your premium. This stems from confusion about basis. If you sell a put at the $20 strike from $1, then when you get assigned, your basis will be $19. I think everyone understands that. But what people do, is then use that $1 premium they collected to buy shares of that stock, and they consider them “free” shares. We know they’re not free, but if you’re buying them with premium, they feel free-ish, since it’s as though someone bought them for you when they paid you that premium. That much makes sense.

Likewise, when people sell a cash-covered put or covered-call and it expires worthless, they have a habit of using that premium to buy, again, “free” shares and then deducting that premium from their basis.

Here’s the mistake: if you use the premium to buy shares, then you can’t also deduct that premium to lower your basis. You have to pick one: Do I want to apply that $1 premium to reduce my wheel’s basis? OR do I want to apply that premium toward shares and think of them as free. You can’t buy free shares, and also consider your basis lowered.

If you mentally lower your wheel’s basis, then when you go to buy shares, don’t consider them house money- your basis on those shares is whatever you bought them for. Alternatively, if you do want to buy shares and consider them free, then mentally take a note that your basis on your wheel has not changed. You used that premium to reinvest in the company, not to lower your basis.

Realistically you’re going to do SOMETHING with the money you collected in premium; you’re probably not going to withdraw it, which would be the truest form of lowering your basis since you now get that cash back. If you want to mentally lower your basis on the wheel, my recommendation would be to put the premium in a buy-and-hold forever stock or ETF like SPY. That way, you can safely consider that money “retired” and lower your wheel’s basis accordingly.

#4: Not regarding intrinsic value. Most of us know that an options price consists of intrinsic value and extrinsic value. New wheel traders, on the other hand, tend to make a mistake on the covered calls half of the wheel. They get assigned at $20, and they want to sell their covered calls for thick premium. So they go down here and sell this $15 call for $5.20. And they get excited, because they just pulled a $520 premium. But here’s the problem: They just agreed to sell a stock for $5 less than it’s trading for, so $500 of this $520 premium is not really extra money, it’s just the $500 between the $15 and $20 strikes. The actual value they gained by selling this ITM strike is only the additional $20 of extrinsic value.

ITM strikes are low on extrinsic value, so you actually gain less by selling them. Instead, the covered call trader should sell OTM strikes so that all of the contract’s value is extrinsic, and they aren’t agreeing to sell a stock for less than it’s worth. If you want to wheel aggressively, you can also sell ATM covered calls.

Selling ITM calls should only be done when you specifically expect a pullback and want to sell some intrinsic value, or when you just really want to get rid of the shares and you are no longer interested in wheeling the stock.

#5: Because we have to do these things in groups of 5, the final note is this: you don’t HAVE to be constantly selling calls and puts when you’re running the wheel. I think the problem people run into too often is that they sell too frequently, and as a result, they miss out on a lot of the shares’ upside.

If you get assigned on a stock that you like, and you expect the stock to rise, then why are you selling covered calls and capping your gain? Of course you want the premium, but if a stock is on the rise, don’t cap your gains by selling covered calls and trying to pick a strike deep enough OTM that it’ll still expire worthless. That’s what people are talking about when they compare covered calls to pennies in front of a steam roller.

Instead, when you get assigned but expect the stock to increase, just hold the shares for a while. I promise it’s okay, 99% of investors just hold shares anyway. Wait for the stock to increase as you predict, and once you are satisfied or the stock looks kinda toppy, THEN go back and sell covered calls. You’ll be well above your basis, and if you get assigned after all, then you will have benefited greatly from the shares rising in value.

Wheel traders don’t have to constantly be wheeling. Let your shares do their thing, and spin the wheel when you see fit.

That’s all this time. I hope you all got something out of this video. Keep wheeling, keep making money, and if you do it the right way, you can’t go wrong. Thanks for watching, and I’ll see you next time.