Improving your wheel with Twisted Sisters

The Wheel is still the strategy I get asked about most frequently. I continue to encourage people to sell Cash-Covered (aka Cash-Secured) Puts to enter the wheel, and then switch to Covered Calls after assignment. In an earlier post, I described how to use Jade Lizards as a replacement to Cash-Covered Puts in order to increase the premium collected. In this post, I'll discuss how to use Twisted Sisters to replace Covered Calls.

tl;dr Twisted Sisters combine a covered call with a put credit spread. Use a Twisted Sister instead of a covered call to pull additional premium and improve your breakeven price when you expect any stock activity other than a massive drop. In exchange, you take the additional risk of making smaller amounts of money if the stock breaks your put credit spread's long strike (though you cannot suffer a loss due to the stock increasing in price when you establish a Twisted Sister correctly). This method is only effective when premiums are high enough to facilitate Twisted Sisters, generally requiring a stock price of at least $25 and medium volatility.

Acronyms used:
TS: Twisted Sister
JL: Jade Lizard
CCS: Call Credit Spread
CSP: Cash-Secured Put (same as a Cash-Covered Put)
c: call
cc: covered call
p: put
AAPL: Apple Stock Ticker

The band Twisted Sister probably had 0 members who used the Twisted Sister options strategy.

What is a Twisted Sister?

I owe you all a video on Twisted Sisters, but it may be months before I have the time to make one. 

Twisted Sisters are a relatively exotic strategy that involve selling a call and opening a put credit spread at lower strike prices. If you have Level-4 options trading, you can set up a Twisted Sister without the short call being covered, but this would entail taking unlimited risk if the stock moons. In the context of Theta Gang, anticipate only using Twisted Sisters to when I own 100 shares. This will ensure the short call is covered and thus prevent unlimited upside risk.

A properly established Twisted Sister will always be profitable to the downside. That is, despite a put credit spread causing max loss if the stock expires below your short put, the premium from the short call will more than offset that loss. However, keep in mind that although the Twisted Sister spread itself will always be profitable to the downside, the loss on shares may exceed the profit from the TS. 

This post will continue by looking at the TS alone in most areas. You will need to consider your shares independently unless it is otherwise discussed.

Example of a correct Twisted Sister:
STO 1x AAPL $305c for $450
STO 1x AAPL $290p for $250
BTO 1x AAPL $285p for $150

NOTE: It is very important that the premium collected be larger than the distance between strikes on the PCS. If it is not, then you are liable to lose money on the spread if the stock tanks. With a proper TS, you will ALWAYS be profitable no matter how far the stock drops (keep in mind that if you are running this as a covered positions, the loss on shares might exceed the gain from the TS spread alone).

You'll recognize the first leg as your Covered Call. This is the backbone of the Twisted Sister. When we sell a covered call, we want the stock to expire just below our strike. If we are confident that AAPL will close just shy of $305, we can add the second two legs to make a Twisted Sister and collect more premium.

You'll recognize the second two legs as a put credit spread. You are opening the spread for $100 credit and the max loss (difference between strikes minus premium) is $400.

If AAPL drops to $285, then we will suffer the max loss of $400 on the put credit spread, but we will realize the full $450 premium from the Covered Call, resulting in a gain of $50.

Conversely, if AAPL were to rise above $305, the put credit spread would expire worthless, letting us realize the full $100 premium. And of course, we would get assigned on our Covered Call. Alone, that cc gives us a breakeven of $309.50. If we had just sold a covered call and AAPL were to rise to $310, we would have suffered a loss of $50 on the short call.

But the Twisted Sister's PCS grants us another $100 premium, so our breakeven is actually $310.50. With the excess premium from the PCS, converting to a Twisted Sister gave us the extra $100 to keep this position profitable even though our breakeven on the covered call got busted. If AAPL were to drop but stay above our PCS, we get another $100 to enjoy versus if we just sold a covered call alone.

Example of an incorrect Twisted Sister:
STO 1x AAPL $310c for $300
STO 1x AAPL $280p for $150
BTO 1x AAPL $275p for $70

Since we are collecting a net of $380 in credit but the difference between strikes on the PCS is $500, then we will stand to lose up to $120 if AAPL tanks. Our goal is to ensure that the TS is profitable no matter how low AAPL goes. This setup will not ensure that. This is not a proper Twisted Sister because it does not remain profitable when the stock busts the put credit spread. We will have to adjust our strikes or our expiration to ensure we collect more premium than the max loss on the PCS.

How can we use Twisted Sisters to improve our wheeling?

If it is not clear from the example above, Twisted Sisters have two positive aspects in exchange for one risk.

On the positive side, TSs improve your breakeven by letting you realize the full premium from the PCS whenever your Covered Call gets assigned. Additionally, if the stock closes between your Covered Call and PCS short strikes, you collect max profit from both sides of the strategy, boosting profits.

On the negative side, you will realize a smaller profit if the stock busts your PCS long strike. While you still realize the full premium from the Covered Call, the losses from the PCS will offset most of it, leaving you with a smaller profit. Again, you cannot lose money from the spread when the stock drops, provided you set up your TS correctly.

Of course, the risk of the stock flying high still exists. If the underlying rises dramatically and you get assigned to sell shares at a strike well below the market price, the premium from the PCS will help ice the wound but may not be enough to offset the loss from the short call. For this reason, it is important not to open Twisted Sisters if your short call is not covered. If you do not have 100 shares of the underlying in your portfolio, you could be stuck buying 100 shares at the market price and selling them down at the strike; the loss from which could be immense. Additionally, it can hurt to get assigned on a covered call way below the market price. Don't sell covered calls at all if you absolutely must have those shares in your portfolio to be satisfied.

When wheeling, the TS allows us to choose more aggressive with our Covered Call strikes because the PCS will grant us additional premium. Likewise, the boosted premiums collected can help us lower our basis more quickly than selling Covered Calls alone.

Real Life Example

Let's play out a real example on AAPL.

AAPL has adequate options volume and premium to make Twisted Sisters a viable strategy.

Let's assume you are wheeling AAPL and are ready to sell covered calls. If you sell the $320c, you'll collect $528 in premium. Your breakeven to the upside is $325.28. If AAPL closes higher than that, you would have been better off just holding the shares.

However, you can add the put credit spread to convert to a Twisted Sister to collect $140 additional premium. That's a bonus 26.5% premium on top of your covered call.

Notice that the max loss on the call credit spread is $360 ($500 between strikes, minus $140 collected). It is very important that the short call sell for more than that in order to ensure you have no downside risk. In our example, this works because we are collecting $583 from the covered call. If your max loss on your PCS is more than the premium you collect on your Covered Call, then you will suffer loss if the stock price drops through your PCS; this would be an incorrectly established Twisted Sister.

Here is how this trade could play out:

The key points to recognize here are that:

1) If the stock drops dramatically, the PCS of the TS will negatively affect you, so you would have better off just selling the Call (this is the risk of TSs).

2) If the stock falls between your CC and PCS short strikes, you will profit  more than if you had just sold the CC due to the added benefit of the PCS expiring worthless.

3) Your breakevens improve to the upside, as demonstrated with this example's $325 expiration price.

4) If the stock goes flying, you will still suffer a loss, but it will be reduced versus just selling a call. Keep in mind that selling this call as a covered call will cause you to not lose money if the underlying goes flying, you will just miss out on more possible gains.

5) If you are holding 100 shares and enter a TS as part of the wheel, the "no risk of loss to the downside" part of the TS goes away because your shares will incur losses as the stock drops. This may or may not offset the guaranteed gain from the TS itself.

Final Thoughts

TSs will not work on low-priced stocks because you are unlikely to find a covered call selling for enough premium to cover the max loss on a PCS. It may be possible if you are looking at an expiration months in advance, but that is a long time to wait to realize the premium.

Robinhood will not recognize a Twisted Sister by name, so double-check your order before submitting to ensure it is established correctly.

TSs have a slightly more bullish bias than CCs because TSs will become a liability to your portfolio if the underlying drops dramatically.

TSs are best used when IV is high following a recent rise and you expect IV to drop. Decreasing IV will help both your PCS and CC, so you will profit more quickly when IV drops, even when stock prices do not.

Disclaimer

Mikey created this post in good faith based on his experience and understanding of options strategies. However, Mikey is not a financial adviser. Perform your own analysis before engaging in any trades in the market. If you are not confident, consult a licensed financial adviser.