Income Investing Strategy (Wheel Options)

Important Note: This strategy is not applicable for Malaysian market because we do not have “Options” to trade

Challenge: Timing an entry price

Any seasoned investor in Malaysia would tell you that there is a price that he/she is looking at to enter a position for any share.

Buy low, sell high = profits.

Simple, yet hard to do, especially when an investor has idle cash on hand and he/she is looking at the share market day after day to hunt down a trade. Every day the idle cash is not invested, that’s a day of no returns for the cash.

However, ever since I started investing in the US, I stumbled upon this strategy that can make generous income whilst we wait for the right price to buy/sell.

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Options-specific Definitions

Before diving into the strategy, let’s go over some basic definitions.

Options	A trading tool that provides the buyer an “option” to take a particular action. Think of it as an insurance for the buyer of an “Option” in case something happens. There are 4 main elements to an Option: – Put vs Call – Strike Price – Expiry Date – Premiums
Put Option	– The buyer has the choice to sell the stocks on hand at a predetermined price – Strike Price – The seller must buy the shares at the “Strike Price” when the Put Option buyer exercises his/her option
Call Option	– The buyer has the choice to buy the stocks on hand at a predetermined price – Strike Price – The seller must sell the shares at the “Strike Price” when the Call Option buyer exercises his/her option
Strike Price	The agreed pricing between buyer and seller of which the transaction of the shares will happen Example: A strike price of $1 means that the buyer of the option will buy / sell the shares at $1 per share when he/she exercises her option. The seller on the other hand have to sell / buy the shares at $1 per share.
Expiry Dates	Once an “Option” reaches the expiry date, the buyer has to decide whether to exercise the option or let it expire and forgo the option
Premiums	Premiums are basically the “Price” of the “Option”. The buyer has to pay this premium to the seller of the “Option”. It’s just like insurance – the buyer of the insurance pays the premium to the insurance seller. How it is priced is a whole different topic altogether, but you can understand more here
Assignment	When the Option is exercised and the buyer of a Call Option / seller of a Put Option gets “assigned” the shares and will be required to pay the price to buy the shares

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Introducing: Wheel Options

The Wheel Options strategy consists of 4 major steps, which I will break it down here.

Let’s say we identified a company (ABC) that we want to invest in.

Step 1 – Sell a Cash Secured Put Options (+INCOME)

By selling a Put Option, we are obligated to buy ABC’s shares at the strike price if the shares drop to below the strike price (i.e. assignment).

In return, we will pocket premiums on the Put Option as we sell them to the buyer. Income generated!

A cash secured Put Option simply means that we have cash ready to buy ABC’s shares if we are “assigned” the shares. However, if the share price do not drop below our strike price before the expiry date, then the Put Option will expire worthless.

This means that we do need to buy ABC’s shares.

It also means that we pocket the premiums forever. Income secured!

Once the Put Option expires without assignment, we will repeat this step. At some point, we may either:

• Decide to change to another share to perform this strategy because prices for ABC may have skyrocketed, or
• ABC’s share price dropped below our strike price and we are assigned the shares.

Step 2 – Assignment of Shares

Uh oh… we got assigned and had to buy the shares.

But then again, it was all part of the plan. It reached the target price that we wanted to buy into ABC’s shares. So all is good!

Now, we just need to wait for ABC’s share price to recover and hit our “target selling price” in order for us to sell our shares for capital gains.

However, let’s not stop there and create more income as we wait for the prices to reach our “target selling price”.

Step 3 – Sell Covered Call Options (+INCOME)

Remember that selling Call Options means that we are obligated to sell the shares to the Call Options buyer at the pre-determined strike price if the share price rises above the strike price.

In return, we will pocket premiums on the Call Option as we sell them to the buyer. Income generated!

This is defined as a “Covered” Call Option because we own the shares that will be sold in case the Call Option is exercised by the buyer.

If the share price do not rise above our strike price, then the Call Option lapses without assignment. Hence, we will still be holding the shares, but the premiums that we have collected upfront will be forever ours. Income secured!

We repeat this step as soon as the previous Call Option expires without assignment. And we keep on doing this until ABC’s share price rises above our strike price, which is also meant to be our “target selling price”.

Also an important point to note – we will earn capital gains from the assignment of this Call Option as we sell our ABC shares at our “target selling price” after buying it at our “target buying price”. Capital Gains profit generated!

Step 4 – Repeat

Now that the full Wheel is completed – we bought and sold the shares – we can repeat this with our freed up capital on the same share or others. The choice is ours to make.

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My Portfolio example

My most recent example was on a company called Limelight Networks (LLNW).

(1) Cash Secured Put Option

I sold a cash secured put option on LLNW

• Share price when I sold the put option was $4.70
• Strike price of $4.50
• Expiry in 38-days
• Premiums of $0.60 per contract

(2) Assignment – buy shares

The share price at expiry was $3.45, hence I was assigned the shares upon expiry as this was below my strike price.

I had to buy the shares at $4.50 per share as that was the strike price of the Put Option.

However, I have pocketed a premium of $0.60 when I sold the Put Option, so my theoretical breakeven price is $3.90 (= $4.50 – $0.60).

(3) Covered Call Options

The moment I was assigned the shares, I went ahead and sold a Covered Call Option

• Strike Price of $4.50
• Expiry in 60 days
• Premiums of $0.15 per contract

This brings my breakeven price to $3.90 – $0.15 = $3.75. As of writing, LLNW’s share price is $3.79, so technically I am profitable on the trade already.

Potential Profits

However, assuming the share price rises above $4.50 before the expiry of my current Covered Call Option, my profit per share will be $0.75 per share:

• Cash secured put option = $0.60
• Covered call option = $0.15
• No capital gains

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Closing thoughts

In my opinion, this is a very good alternative to the conventional buy-hold-sell way of investing that we are so accustomed to. It is boring, but it works wonders, especially in the US market.

For foreign investors, we are required to pay a hefty withholding tax of 30% on dividends earned from US shares. Hence, this way allows us to earn alternate income whilst waiting for the right prices to buy/sell.

There are some challenges worth noting about this strategy as well:

• 1 Option contract represents 100 shares so it is challenging for small accounts to exercise this strategy on big cap stocks (e.g. 1 option contract on TSLA requires $650 * 100 = $65,000 to execute this strategy)
• Options may not be available (or quite limited) for shares that we are looking at as it depends on the “popularity” of the particular shares
• Premiums available on Options may not be attractive depending on where the share price is
• Profits on capital gains are limited based on the strike price that we set (e.g. my LLNW may not have any capital gains)

This boring strategy, with its challenges, are quite well suited for boring shares that usually trade in a price range.

Happy investing!