September 17, 2024 – Welcome to another installment of my Options Trading Series. Please click here for the Options Landing Page for more details about the strategy. People frequently ask me how I deal with losses when I trade my options strategy. My approach is that a loss is water under the bridge, and I run the same strategy going forward, albeit with a slightly smaller account size. I’ve been trading my put options strategy since 2011, and this approach has served me well in several significant equity drawdowns, most recently in the 2022 bear market.
However, some of the options traders who have found my blog over the years must be big fans of the so-called “Wheel Strategy” (or “Options Wheel” or other related terms) and ask me all the time if it wouldn’t be better to take possession of the underlying, and then sell covered calls until I recover the loss. This strategy is often marketed as a great risk management tool and a surefire way to claw back losses.
I’ve previously dismissed this idea and given short and curt answers. But since the issue keeps coming up, I want to publish a more detailed post explaining why I don’t think the Wheel Strategy holds up to all the hype on the internet. Let’s take a look…
How do I deal with losses?
I believe my strategy is sound. It’s not a matter of if I ever suffer a loss, but when. Losses in options selling are a natural part of life because nobody would buy options from me if they had a zero chance of ever going in the money. In the long term, I make money because implied volatility far exceeds realized volatility, at least on average. So, my approach to dealing with losses is simple: If I suffer a loss, I keep doing what I have been doing and eventually recover.
Below, I plotted my daily cumulative put-selling profits in 2020. As you can see, I suffered small losses in January and February when some of my puts went sour. But I never deviated from my strategy. Quite intriguingly, I made money in March 2020 when the pandemic crap hit the fan. There was one single-day loss, but it recovered the next day. If you recall, in 2020, we only had the Monday, Wednesday, and Friday expirations, and my Friday short puts – sold on Wednesday – got hammered on Thursday, only to recover again on Friday. A similar effect is responsible for the June spike in the P&L.
To summarize, the losses in January and February were locked in at the expiration. But I made the money back doing what I do best: selling naked put options. I never felt that I needed to deviate from my plan. Quite the opposite, stoically selling my puts after a significant volatility spike tends to be quite profitable and also relatively safe because some of the puts I sold in March 2020 had strikes 20 or even 25% out-of-the-money at very sweet and rich premiums. Even when the market fell further, I recovered from my February loss in record time. I never felt I needed to change course after a loss.
Another example is the recent volatility spike on August 5, 2024. Luckily, I didn’t even lose money on the August 5 puts (my strikes were between 4800 and 4975 when the index fell to “only” 5119 intraday and 5186 at the market close). And the subsequent days offered some of the best put-selling revenue all year; see the chart below:
Other events where I suffered losses in the past, like in August 2015 or February 2018, showed similar patterns: the volatility spike ensured that I recovered the losses in relatively short order within a few months without ever changing my strategy.
What if someone had searched for another approach? People would have likely recommended the Wheel Strategy. This brings me to the next section. Let me first define what the Wheel Strategy does:
What is the wheel strategy?
If you sell puts, you often create reliable income for extended periods. You sell the downside protection, but the stock goes sideways or up or at least doesn’t fall enough to reach the strike. But what if the put goes into the money, i.e., the underlying falls below the strike? What if the option is executed? Under the wheel strategy, you take delivery of the underlying and then sell call options against that position, ideally with the same strike as the put option earlier. Then you cross your fingers that the drawdown is temporary, and the stock finally reaches that old strike price again. When the option is assigned, you sell your stock at the strike price; you now have the same cash position as before, plus the additional options-selling income. Sweet!
Well, what’s not to love about this strategy? Here are six reasons why I am highly suspicious of the efficacy of the Wheel Strategy…
1: The Wheel Strategy ignores market history
The options wheel has had a good run in the last few years, though even in almost perfect market conditions, some people still managed to destroy their portfolios; more on that in item #5 below. However, those perfect market conditions were only present because the two recent bear markets were short and shallow. Let me display some historical bear market stats in the table below. These are my personal calculations, where I define a bear market as a 20+% drop below the recent all-time high and the confirmation of a new bull market as either a new all-time high or a 30% recovery from the bear market bottom. I use daily data for the S&P 500 market close (or predecessor indexes early on). I use only post-WW2 data to calculate the mean, median, and standard deviation, but I will also display the 1929-1932 bear market data. All data are nominal price returns, i.e., I do not perform any CPI adjustments, and dividends are excluded, too:
The 2020 and 2022 bear markets were some of the most benign market events. The lengths of the 2020 and 2022 bear markets were less than a year (compared to 1.3 years for all 12 post-WW2 bear markets, three years for the worst, and 2.73 years for 1929). The length until the SPX index recovered was also short: only half a year in 2020 and about two years in 2022, much shorter than during prior bear markets (3.6 years on average, 8+ years in 1946-1954).
Of course, 1929 takes the cake when it took 25 years to recover to a new all-time high. That would have ended your wheel strategy. But we don’t even have to go that far back to identify some trouble with the Wheel Strategy. The 2000 bear market recovery took until 2007, right before the start of the next recession, which took another 5+ years to recover fully. So, between early 2000 and mid-2013, the S&P 500 index spent most of its time underwater, with drawdowns as bad as 56.8% in March 2009. Most of the time, there would have been very little income when selling call options at or around the 1500 level because the S&P 500 was so far below that level. If you had to live off the dividend income only during all those years, that would have been a measly cash flow out of your portfolio. Certainly less than the 30% or even 60% returns that some scam artists on YouTube are touting. The wheel strategy would have failed spectacularly over those 13 years; see the chart below:
2: The Wheel Strategy is too risky when using leverage
This criticism may not apply to all YouTube options traders because some “Wheelies” use no leverage, i.e., they sell only 100% cash-secured short puts. In other words, if they sell a put option at a strike of $50, they’d have $5,000 in margin cash sitting around in their account.
But I am exclusively trading CBOE SPX index options. Without leverage that wouldn’t generate enough revenue when trading far out-of-the-money options, the most attractive from a risk vs. reward point of view. I currently use about 3.3x leverage (as of September 2024). And just for the record, here’s how I define leverage. Take the following example: The SPX trades at 5600 points. I sell a put option with a 5300 strike, with a notional value of $530,000. This is also equal to the naked put maximum loss if the S&P 500 were to drop to zero. If I have $160,000 in capital per short put available, you’d have about 3.3x leverage because $530,000/$160,000=3.3125.
What can possibly go wrong if you use the wheel with leverage? If the drawdown is deep enough and you are assigned the underlying, you’d have a massive short cash position and be hit with margin interest unless you trade futures options and now find the futures contract in your account, e.g., the ES = S&P e-mini futures. And what if the underlying drops another roughly 30%? You’d wipe out your entire account with 3.3x leverage. So, the wheel only works if you can generate an attractive enough cash flow from an unleveraged portfolio. For me, as a CBOE SPX options trader, there wouldn’t be enough premium. But certainly, for some high-volatility tech stocks, you could collect enough premium without leverage.
I would also like to stress that CBOE SPX options are cash-settled. There is no assignment, so I’d have to revert to the ES e-minis again to guarantee the delivery of the underlying. So, the wheel is not just too risky but also cumbersome for us SPX traders.
3: The Wheel Strategy is a tactical valuation strategy in disguise
Suppose you run the wheel strategy with a 20-Delta Put. Moreover, assume that once assigned, you sell a call option at the same strike. Since the underlying is below the strike, we know the option Delta is below 50. Since the underlying has a Delta of 100 and the short call subtracts less than 50, we now have a net Delta of more than 50. What if the stock falls further? What if the stock falls so far that the call option at that old historic strike is essentially zero? Now you have a net 100 Delta.
Do you notice a pattern? The more the stock falls, the more Delta, i.e., the more stock exposure you seek. In extreme cases, you go from 20 Delta to 100 Delta. You run a tactical asset allocation strategy based on valuation. Some people double down after a trade goes sour. Some wheelies would effectively quintuple(!) down after a large enough loss. Betting against the market, especially doubling and quintupling down too early during the bear market, can lead to very painful losses.
Of course, I need to stress that there is nothing fundamentally wrong with valuation principles. Valuation can be a very useful guide in financial planning. For example, I’ve written in my Safe Withdrawal Series that the Shiller CAPE is an excellent measure to gauge your sustainable safe withdrawal rate. The CAPE correlates highly with Sequence Risk because it correlates with long-term (10+ years) return expectations. The only problem is that valuation is often a terrible short-term asset allocation strategy. Valuation screamed at you to sell stocks in 1996 when the party continued a lot longer. Valuation screamed at you to buy more stocks in 2008 when the S&P dipped below 1,000 points. Only to drop to 666 points in March 2009. The saying “the market can be wrong for longer than you have liquidity” comes to mind.
And by the way, sometimes the market isn’t even wrong, neither in the short or long term. Some “wheelies” got clobbered with stock tickers like RIDE (Lordstown Motors, bankrupt), PTON (Peloton, down 97% since the peak), ARKK (down two-thirds since its peak), and other disaster stocks that will never reach their old all-time high again. One prominent “wheelie,” Markus Heitkoetter, even recommends buying additional(!!!) stocks to lower the cost basis, thereby exacerbating the tactical valuation shifts (“catching a falling knife”). I wonder how that worked out with RIDE!
To summarize, we can identify in what kind of market condition a Wheel Strategy would perform well and when it performs very poorly: If we have merely choppy markets with quick mean reversion, then this strategy could do OK. Unfortunately, the Wheel Strategy hedges against the kind of market volatility we shouldn’t fear much, namely, the stock drops and recovers swiftly.
In contrast, this strategy will perform horribly if we have downward trending markets. Specifically, the Wheel Strategy will perform poorly in the market environment everyone fears, i.e., a long downward momentum market like the Great Depression or even the Dot Com bust or Global Financial Crisis that takes down all or most of your stocks for a deep and long drawdown. Think of all the past events that caused bad Sequence of Return Risk for retirement cohorts! Those are also the widowmakers for wheel strategy traders. As an early retiree, why would I want to employ a strategy correlated with my number one risk in retirement? That’s why I wouldn’t touch the Wheel Strategy with a ten-foot pole!
4: The Wheel Strategy is mathematically and logically inconsistent
Let’s assume we have two identical investors in every dimension: age, gender, location, tax bracket, portfolio value, etc. Assume both investors have $80,000 in their respective portfolios and would like to employ the Wheel Strategy.
Investor 1 is just starting with the wheel strategy, and she’s considering stock XYZ, which has a current price of $100. She employs the Wheel Strategy and sells ten put options with a strike of $80 for $2 each. The options have a Delta of -0.20, and since she writes (=shorts) the puts, the portfolio has a +0.2 Delta. Notice that Investor 1’s portfolio value exactly covers the notional value of the puts: 10 times 80 times 100 equals $80,000. All short puts are cash-secured.
Investor 2 also has a portfolio worth $80,000 consisting of 800 shares of stock XYZ, each valued at $100. These 800 shares resulted from a prior application of the wheel strategy, where 800 shares were assigned at a $120 strike after the share price dropped to $100. So, to stick with the wheel, Investor 2 now keeps those 800 shares but sells eight call options with a 120 strike for $2 each. Assume the calls have a Delta of +0.20.
Someone needs to explain to me how two otherwise completely identical individuals who have the same portfolio value and like the exact stock ticker choose such fundamentally different asset allocations. Investor 1 is cautious with a net Delta of 0.2, i.e., a portfolio equivalent to only $16,000 in stock exposure. In contrast, Investor 2 is very aggressive with a net Delta of 0.8, i.e., a portfolio with the equivalent of $64,000 in stock exposure. Why would the Wheel Strategy recommend such drastically different optimal portfolios? They can’t both be optimal. One explanation is that Investor 1 is doing the right thing. And investor 2 probably has a behavioral bias called loss aversion, i.e., acknowledging a loss is so painful that people are often willing to take significant risks to dig themselves out of it – by hook or by crook.
Of course, one could also argue that Investor 2 is intelligent and enlightened enough to realize that after the recent drop in XYZ’s share price, it is now poised for a rebound. This is obviously how the Wheel Strategy is justified, namely as a tactical asset allocation shift (see item #3 above), where after the significant drop in the share price, you go whole hog and bet on a quick recovery. Maybe that’s the right course of action, but why isn’t Investor 1 privy to that idea? We are mixing two investment flavors – option selling and short-term valuation/mean reversion – and shifting the weights back and forth between them but inconsistently across different investors. So, the Wheel Strategy is an exercise in futility and irrationality.
5: The Wheel Strategy is perfect for scam artists
You can tell a lot about an investment strategy’s credibility by looking at who recommends it. Lots of scam artists push the Wheel Strategy! The first obvious reason is that the strategy can be sold with phrases like “can’t lose,” “foolproof,” or “recession-proof,” etc.
But here’s another sinister reason the wheel strategy is popular with scamsters. It’s an ideal way to hide losses. A lot of options influencers report only their realized Profit and Loss numbers. Then, they can hide their unrealized losses behind the Wheel Strategy, specifically, the underwater shares they own in their portfolio with a cost basis equal to the put strike that previously went sour. So, as long as you never liquidate your portfolio’s stinker stocks, you never realize those losses.
So, to give you an example, imagine our scam artist has a portfolio worth $100,000. He sells put options on ten different stocks, each with a strike of $100. The price of each is $2. Each put option has a multiplier of 100x, as is customary. So, we’ve generated $2,000 in option revenue (10 options times 2 dollars times 100 multiplier). Now assume that at the expiration, eight puts expired worthless while two ended up under the strike price, one at $90 and one at $80. What was the P&L of this trader? Very simple, we can add up the P&L over the ten short puts: A gross $2,000 gain from the options premiums and a capital loss of $3,000 from the two stocks. It’s a net $1,000 loss:
Alternatively, we could look at the account’s total value in t=0 and t=1 to get the same result. The portfolio started with $100,000 in cash. We gained $2,000 in options premia, but we also had to spend $100 per share for 100 shares each in stocks 1 and 2. So we’re left with $100,000 – $20,000 + $2,000 = $82,000 in cash in our account. The two stocks are worth $9,000 and $8,000, respectively. Again, the account lost $1,000:
But do you know what less-than-honest YouTube influencers report? Since the capital losses are still unrealized, you don’t hear about them. So, our Youtuber will proudly report that the account generated $2,000 in profits. You know, because they believe that all stocks always recover, so they don’t worry about temporary losses. How sneaky! Here’s a Reddit post where folks discuss this dishonest practice.
Not considering realized losses is just plain reckless, if not fraudulent. In accounting, it’s often customary that unrealized gains are not yet booked. However, unrealized losses should always be noted in the books through impairment charges. You hold back your unrealized gains and losses only for income tax purposes. But I’m not the IRS. Before I take a trader seriously, I need to see accurate P&L statements with both realized and unrealized profits and losses.
Without naming any names (I don’t want to get sued), I think many options trading gurus push this methodology precisely for that reason. This is quite literally the Enron method of accounting, i.e., you hide losses elsewhere and report only the positive income. So, because of this accounting trick, please use extreme caution and take all profit and return claims of the options trading YouTubers with a grain of salt! Many YouTube Options influencers are sitting on massive unrealized losses, often exceeding their realized trading gains all the while claiming 60% annualized “returns.”
And just in case you wondered, the YouTubers will be OK. They make all their money from selling courses, books, memberships, newsletters, YouTube ad income, etc. Think of them as the Robert Kiyosakis of the options trading scene. However, you, the retail trader, will likely have less success with this strategy!
6: You’d better be a good stock picker to make the Wheel Strategy work!
For full disclosure, some YouTube influencers, to their credit, will acknowledge that the Wheel Strategy has the fundamental problem of long and deep drawdowns ruining your performance. But then, in the same breath, they will point out that you don’t have to worry about those drawdowns because you’re only doing the cash-secured put selling with “good stocks,” i.e., carefully screened stocks you know can’t fall for an extended period. Ah, that’s good to know that the options gurus on the interwebs are now not just expert market timers – see item #3 above – but also world-renowned stock pickers. Of course, I’m being sarcastic because here’s a newsflash: good and bad stocks only reveal themselves after the fact. Thousands of stock pickers have already screened all the information you can gather from the news or financial reports. Efficient markets would have priced in all the available information within milliseconds. The fact that so many wheelies fell victim to RIDE and PTON is an excellent testament that these clowns cannot screen out the bad stocks a priori.
So, I would not believe any tall tales that you can reliably mitigate the wheel strategy’s worst-case scenario of a deep and extended drawdown. First, you’re not a good enough stock picker to pull that off, and second, sometimes even the good stocks will draw down in a bad enough market event; see item #1 above.
Conclusion
Don’t get me wrong: I believe 100% that selling options is a fundamentally profitable strategy. Most of the time, implied volatility is higher than realized volatility, which is precisely why selling options is bound to make you money over time. But options trading is also inherently risky. The Wheel Strategy is one of the purported solutions for dealing with that risk. I can certainly see how unsophisticated investors find this approach intriguing and attractive. I believe the wheel strategy is a terrible idea for me personally in my short-put trading strategy. Even a casual look under the hood proves this approach is far less reliable than some folks claim. In some cases, the Wheelies are running outright scams to make their results look better. To all readers who follow my approach, I discourage you from using the Wheel Strategy in the strongest possible terms.
Thanks for stopping by! I look forward to your comments and suggestions below!
Please check out the Options Trading Landing Page for other parts of this series.
Picture credit: WordPress AI
Thank you for breaking this strategy down in such detail. I’ve been chalking this up to Too Good To Be True, but that’s probably overly dismissive. It’s just another high risk strategy for traders who struggle to accept a loss. Thanks for providing another great read!
I would argue against the notion of “high risk”. It’s actually the opposite: The options wheel is much less risky than just buying and holding the stocks or indices outright. The risk on the downside is mitigated by (a) always buying lower than the market price at the time you committed to buying the stock, and (b) earning premiums during periods of underperformance. Of course the upside is also limited because you don’t benefit from volatile breakouts as your position gets called away in that situation. This means the options wheel has overall lower volatility than a buy & hold strategy. I have a number of tickers where my position is still in the red after years of underperformance, but accounting for premiums I made 20% or 30% on the stock overall. You don’t get that kind of safety net from a buy & hold portfolio, which is why as a cautious low-risk investor I like the wheel so much.
In my post, I acknowledged that Wheel Strategy has a lower Delta than a plain equity holding, unless the losing position goes so far below the prior strike price that the short call has a 0 delta.
But I hate this strategy because it will occasionally have a much higher net delta than my put selling strategy.
You’re right, “high risk” was an unfair description and you and others below make some good arguments for incorporating into certain trading strategies.
Whew! Thanks for confirming. Glad we agree on this one! 🙂
Thanks! Yes, there’s no free lunch!
I have personally found it to be very profitable (steady but profitable). No overnight riches though!
Yep! Getting rich slowly. Suits me. I don’t have to win the lottery anymore. Just adding a 1% extra return is enough.
I believe there is an investment strategy for every type and character. And the Wheel Strategy is a good one for a certain type. I myself came to it from the side of a deep value investor who looks at undervalued sectors, buys a basket of stocks from that sector (because I’m not good enough to pick any one individual winner) and then wait for the sector to recover within a timeframe of 3-5 years. Think unloved offshore oil stocks, uranium stocks or a regional market like Brazil. Where you have a thesis where it’s not so much IF if that particular market segments recovers, but WHEN. Waiting for that recovery can be painful and often takes longer than expected, diminishing returns even when the breakout inevitably comes. But with the options wheel I can trade around this bottoming period without having to be too nervous about exposure, because the case for an eventual recovery is very strong. The main risk of the wheel in this situation is that when the recovery eventually does happen, the breakout is often so volatile that I will be called and I miss out on a sudden upside. But that’s fine for me, because I had been raking in premiums during previous years. And once the risk/reward situation is not asymmetrical anymore after the breakout, I move on to another sector. This strategy has worked well for me since 2019 with returns oscillating between 8-17% (factoring in for unrealized losses, which you rightly point out, always need to be accounted for). What this strategy of course also implies is that you don’t just sell calls at a previous strike (where you’ve been assigned your put option), but that you’re willing to sell calls at lower strike prices if the market goes against you for longer periods of time. That sometimes results in realized losses, which you just have to accept (much like you do when your put is in the money). But over time, you still win. They key of this strategy is to only ever sell puts on stocks in a sector that you strongly believe in, and that you don’t mind holding over a long period of time even if they go through a bear market, because a recovery is very likely. That means of course staying away from any stocks that even remotely smell like financial trouble, because bankruptcy is your end boss against which you always loose 😊
I’m not saying that for a stock picker like you the Wheel Strategy is bad. It might be a decent alternative if you’re uncertain about the correct entry and exit prices.
But I’m not a stock picker. I run this strategy on the index only and I don’t like to have a lot of equity beta/delta. I like to milk the vol premium. For that purpose, the Wheel Strategy sucks for the reasons outlined above.
Thanks for doing this on the Wheel Strategy. What do you think about using a trend indicator on top of the wheel strategy, so that one would only trade in an uptrend? I think your argument is that it cannot handle prolonged downturns.
That momentum info is already priced into the market by all the other stock pickers. I’d have no illusion that you will gain much.
And yes, the beef with the Wheel Strategy is that prolonged downturns would be poison for this approach.
I’ve personally found the wheel strategy to increase my XIRR Investor return as a “loss reducing” strategy. I make some significant changes compared to the widely accepted strategy however.
My biggest change is I use it as a way to “exit” a trade gone bad. Instead of selling same strike I sell the at the money call under 30 dte getting ~50 delta. I do this on individual stocks, I don’t know how this backtests on index options.
There’s a lot of reasons why the wheel works well:
1. Waiting to be assigned maximizes the amount of theta collected left. If your .20 delta put goes to .80 – put call parity suggests that you now have a .20 delta covered call position.
2. Waiting maximizes the chance the counter party makes a mistake (early assignment when there’s still theta left, ignoring div arb.)
Then once I’m assigned, selling the .50 delta call has a ton of benefits.
1. It’s a mean reversion play. There’s a lot of fundamental reasons why an individual stock might recover after a 1+ sigma move: short sellers covering, value investors buying, technical analysis traders making mean reversion plays.
2. The theta is much higher for a much higher IV. Most downward moves are sticky strike so you’re now selling ~40 IV at the money calls instead of say ~40 iv .20 delta puts.
3. You’re absolutely right it’s a martingale play. However my revision is more like a 2x increased delta risk for the same notional value. On the other hand keep in mind of your notional size going into the trade. You still have the same notional size as your original .20 delta short put trade. My revision also hedges the repriced expected move too.
4. You can also sell deep itm calls at .80 Delta which under put call parity it’s equivalent to shorting .20 delta puts. It’s a great trade on portfolio margin if the bid ask spread is good.
5. Speaking of the bid-ask spread (and put-call parity) wheeling is generally better than trying to roll illiquid ITM puts.
6. Outside of portfolio margin reg-t makes wheel strategies use less leverage than rolling ITM puts due to 50% initial margin vs how naked puts are margined. Going with my .50 delta adjustment makes a reg-t trader maximizing margin have to down size with wheeling to the same delta adjusted exposure given 50% initial margin requirement of long stock vs 25% of short puts for most brokerages.
Then you’re absolutely right that PnL reporting is murky with the wheel. However you can certainly make the same argument for rolling short puts same strike and down and out – you’ll accumulate wash sales etc which changes the taxable pnl.
Anyone worth their salt reports an XIRR return based on NLV which wheeling and rolling can’t hide from.
Overall I find my refinements to wheeling incredibly successful on individual stock options trades as a trade repair strategy. Going with short .50 delta calls means on average I exit 50% of my trades in one opex, 75% exits in two, and 87.5% exits in three. Wheeling once at .50 delta on average reduces my loss by 50% which is huge. So there’s certainly merit to wheeling correctly.
I 100% agree same-strike wheeling is likely sub optimal.
Thanks for weighing in. You certainly know more than the Youtubers marketing the Wheel, haha!
You make a good point: If you sell a Call with a much higher Delta, you would mitigate some of the issues. For example, if you sell 20D puts and then 80D Calls later if assigned, you’re back to the equivalent of a 20D Put strategy. That would be equivalent to maintaining that original 20D Put strategy thanks to P-C Parity, as you correctly state. An ATM call (50 Delta) would still be a bit off but potentially better than chasing after the potentially much higher strike.
Also noted: the deep ITM calls might have large B/A spreads.
Also, note that I don’t have many of the issues you mention as an SPX trader without assignment and using Portfolio Margin. I recommend my strategy to large accounts with Portfolio margin only.
Thanks for the refreshing perspective on the Wheels strategy.
One thing I am surprised and curious about is your stop management. If I recall correctly, you do use stop loss orders. On August 5, vola had skyrocketed at market open and I would assume that, especially with far OTM puts, prices at this point had blown way past any stop. How did you get out of your trades without incurring huge losses? At what % do you set your stops? And do your stops work outside RTH?
August 5 was a crazy day. Even though my strikes (4800-4975) were well below the open that day (5151) and even the low (5119). At the open, the quotes for my puts all shot above the STP I would normally set. So, I made the executive decision to just let it run. It turned out the right decision in hindsight.
My STPs are only during RTH. Not enough liquidity outside RTH.
Had I liquidated my puts that morning, I would have suffered a loss of about 1.3-1.5% from the puts that morning, so it wouldn’t have been fatal.
As you can see, there is still some discretion and intuition necessary. I felt the drop was overdone that morning.
Would increasing the STP quote helps? The tradeoff is it may end up with bigger loss. But still selling put without STP could risk much bigger loss potentially. The question is how to achieve the optimal balance of risk and reward.
You mentioned two weeks to one month premium for the STP quote. What input you would use to decide two weeks or three weeks or one month premium for STP quote? Thanks!
A higher STP is a two-edged sword: fewer false alarms, but sometimes you wait too long and lose more than you should have.
I am hesitant to publishing my exact STP parameters because 1) sometimes they change and 2) I don’t want all readers to copy everything I do down to the STP prices because people might front-run what I’m doing. So, folks have to play around with the details and find the setup they like.
Thank you EARN would anything change if you do the wheel on SPY for example than individual stocks?
I personally favour your approach because the goal is the earn the juicy put premia instead of selling covered calls which are not as rich in premia than the puts.
A Backtest would be interesting if you just get assigned in SPY and write covered calls or if you get stopped out and write new puts instead of getting assigned. I personally think it should be more profitable to get stopped out and write new puts
Obviously, SPY or SPX would eventually recover, which is not guaranteed for individual stocks. But as I demonstrated in my research here and other blog posts, drawdowns in the SPX can also take very long: https://earlyretirementnow.com/2019/10/30/who-is-afraid-of-a-bear-market/
I will defer the backtest to others with more data subscriptions.
1) When you sell puts with leverage, do you mean that you do not have 100x the strike price sitting in cash? I.e. the margin requirement on a way-OTM cash-settled index option is maybe a fraction of that because 1-2 day downturns are rarely bigger than, say, 15%? Or do I remember you saying you can essentially day trade 0DTEs with free leverage because interest is only charged on margin held overnight?
2) Wherever an investor is in The Wheel – selling CC’s or selling puts, their risk profile graph looks similar: unlimited downside and limited upside. This is technically the same risk profile as your short put positions. If the wheeler simply sold any assigned stock and resumed selling puts, they’d be very close to your strategy. So does the performance difference lie in (a) the duration of the options, where you are taking tiny bites and they are often going out weeks, (b) the delta allowing a much higher risk of assignment for the average wheeler who is swinging for the fences, (c) the choice of underlying: assignable stocks versus cash-settled indices, or (d) the lack of leverage in the Wheel strategy vs the ERN strategy?
3) What sequence of returns would cause the ERN put-selling strategy to have a negative annual return? A one-day 15% flash crash? A five day downward stairstep with each day falling below the strike prices of your low delta puts?
1: I have less account value than the notional of the short puts. I call that leverage.
2: The difference is in Delta, DTE and instrument, obviously. But the Wheel also has the difference that you now have very different Deltas depending on the path of the market. That’s undesirable.
3: You can’t tie that to a specific % drop. I’ve seen a 12% drop in March 2020 and that was the best month. You’d need very low IV before the drop and then a large enough drop. We’ve not seen that in the S&P 500 for a long time (or even ever).
Unless the STP could not stop the bleeding, everyone is rushing to the door. What can we do to counter that?
I had this case on 8/5/2024: At the open everyone was rushing to the exit. Since my strikes were still well below the SPX, I just hung tight and it worked out in the end.
Big Ern. Always a fan since I’ve heard you on White Coat Investor. Follow you closely now.
What are you thoughts about selling an out of money put and then if stock starts dropping, using dynamic hedge to reduce loss.
Do you mean deep OTM, long-dated puts? I’ve written a post warning about those.
https://earlyretirementnow.com/2021/05/03/passive-income-through-option-writing-part-7-careful-when-shorting-long-dated-options/
I still sell some deep OTM spreads (say short the 2000 SPX put, long the 1000 SPX put, 120 DTE) but just very occasionally. So far, it’s worked well. I also do this tactically, like after a large drop and vol spike. But my bread-and-butter business is still the 0 and 1DTE, fetching 90% of my revenue.
I like the idea of Delta hedging. It certainly hedges against a negative momentum event, which is what we should fear from the Sequence Risk perspective. But Delta-hedging may be hard for the average retail investor.
Hello ERN, like a lot the content here. I have a question for you, not related to this but related to the recent election in the US. My view is that democracy is now dead or about to be dead in the US. We will now live in something that is a bit like Russia. A dictator like figure helped/controlled by oligarchs billionaires will rule America. They will not leave in 4 years, they will find a way to rig elections and stay in power. You may or may not believe this but let’s assume you do for my questions: What investment strategy would you suggest in this case? do you think the US stock market would still be a good investment? I don’t think countries where democracy is not present had very good returns historically correct? People in charge will not on purpose destroy the stock market, but the corruption and the fact that the rule of law will not exist for the ultra-rich will certainly affect potential returns? anyways, would appreciate your views on this. Thanks!
We are not a democracy but a Constitutional Republic. We just had a free election and will keep having free and fair elections again in 2026 (Midterms) and 2028 (presidential). Anybody who claims otherwise is a total buffoon. Anybody who claims we’re like Russia is deranged.
This constitutional republic has generated a most impressive growth story for the last 248 years. If you don’t like it here, I suggest you move to Canada. But be advised: Canada has had a pathetic economy in the last 10 years compared to the USA. The Canadian stock market also severely lagged behind the US market during both presidencies, Trump (2017-2021) and Biden (2021-current).
Good luck!
Big ERN, thanks so much for your work! What are your thoughts on owning the underlying index and selling 0dte covered calls atm while also buying a 2 year leap put at the initial purchase price. The cost of the put is recovered in the first few weeks while harvesting the daily option premium. Obviously, the cost per day of the put is only a fraction of the 0dte call premium.
I have neither simulated nor used that strategy. I prefer my approach with close to zero Delta over the roughly 50-delta strategy of selling ATM covered calls, though. The best risk-adjusted returns are in the far OTM puts.
The chart title has a typo: gross is black, not green.
I corrected the typo. Thanks a lot! How come nobody else noticed that yet? 🙂
I can see the Wheel strategy working with dividend paying Blue Chip stocks with less volatility, although premiums may be less fruitful, but those who chase higher premiums by selling Puts on more volatile stocks and utilizing the Wheel strategy are going to get hurt. I write Puts, but haven’t lost any money, as I choose to just Roll Down when the play goes against me. Couple this with going with a Blue Chip stock, and it works quite well. I average 2% monthly. Of course, I’ve had plays where my strike price was met, and the stock even dropped below. I just move the goal posts by buying back the ITM Put and then immediately selling the same strike price (or even lower to decrease my Put obligation) a week or two out (sometimes more but never beyond a month out). I just make sure my credit when doing so is always positive, so I never lose money… I just have to wait a little longer. If things don’t improve for the stock by expiration, I just Roll Down again. You can do this indefinitely and every time you do so, you make sure the Roll Down is a net credit positive. If there is anything wrong with this strategy then please let me know, but it has worked flawlessly since implemented, however, maybe I’m missing something?
None of my points here rely on low vs. high volatility or high vs. low dividend yield. In fact, a high dividend payer that gets crushed and then has to cut dividends will also kill the wheel strategy. Think Bank of America post-2007. So, to summarize, the wheel strategy is bad for all the reasons I pointed out here. But I’m glad the strategy has worked for you so far. I wonder how many years of experience you have, though. Did this work for you in 2020 and 2022?
Great article, gave me a lot to think about regarding the real risks behind the wheel strategy. Thanks for sharing!