The Wheels on the Bus
There is a children’s song I remember from my very early days. The song goes, “The wheels on the bus go round and round, round and round, round and round. The wheels on the bus go round and round, all through the town.” Wheels are a figure of something that can keep going or is repeated. There is an options strategy that is called the “Wheel Options Strategy.” I found that Markus Heitkoetter does a nice job explaining this strategy in a 15-minute video. You might want to watch it at this LINK. However, I want to illustrate the process I used to start a wheel strategy trade for Cindie on Friday using HP Inc (HPQ).
Finding the Right Stock for the Wheel
This strategy will work best if you pick a stock that meets some criteria, especially if it is your first attempt at the wheel approach. The stock you want should be a value stock, not a growth stock. You should focus on a stock that pays a dividend and that has a relatively low P/E ratio. HPQ fits all of those requirements. In addition, you want to use this strategy with a stock that trades weekly options, not monthly options.
Markus also suggested you pick a stock trading in a sideways range. That means it is not shooting up or falling quickly in price. It should gravitate between a high and low price. In HPQ’s case, the stock has been trading between $26 and $29. There have been some peaks above that range, but the general trend has been sideways. This lends itself to the wheel approach. Furthermore, in spite of this stock price behavior, HPQ’s dividend has been growing.
Finally, the business needs to be making money and the dividend ratio should be rational. In the case of HPQ, check and check. HPQ’s forward expected earnings are $3.32 per share and the dividend payout ratio is just under 25%. This is perfect.
The Pieces of the Strategy
If you have read the first twelve posts in this series, you should know that I have traded covered call options and cash covered puts. Both of them earn me a premium. In other words, I am selling my option contract to another investor, and they pay me for the contract agreement. The wheel strategy starts with a cash covered put and then, if the shares are assigned to me, it changes to a covered call options trading approach. To state this simply, I am willing to buy HPQ shares at $27 using a put contract, and then I am willing to sell those shares for $29. This gives me the opportunity to earn up to three (if not four) pieces of income.
The first piece is the premium I receive for selling the $27 put contract. Then, I can sell (until the shares are called) covered call contracts at $29 per call contract and receive a premium for each trade. Then, if the shares are called away, I make a profit of $200 ($29-$27 x 100 shares). Finally, depending on how long this continues, I may also take in some dividends.
The Earnings Date
Although I don’t think Markus mentions it, I think it is wise to at least be aware of any upcoming earnings or ex-dividend dates. The contract date I selected was January 20, which is before the earnings date. There is no Ex-dividend date until March.
Resistance and Support
Resistance is the theoretical boundary that says “it will be difficult for the stock to rise above this price.” For HPQ the 40-day resistance level is $29.09. The support boundary is the stock price that seems to cause buyers to get interested and start buying, increasing demand for the shares and usually causing the price/share to rise. The 40-day support level for HPQ is $26.86. Therefore, I want to buy shares at $27 using the put option and then sell them at $29 using the covered call option contract.
Cash Covered Put Review
If you sell a cash covered put contract with a contract price of $27, you must have $2,700 in cash available to buy the shares if the share price drops to or below $27. If you don’t have the cash, then you cannot “cover” the put.
Experimenting with Prices and the Bid/Ask
Using Active Trader Pro (ATP), you can see that the last trade for a put option for January 20 was $0.15 for the $27 contract. However, someone is asking for $0.19. I started by asking $0.18 and then, when there were no takers, I adjusted my contract price to $0.16 per share. This resulted in a trade. Cindie now owns the right to buy 100 shares of HPQ at $27 if the price of the shares falls to that price or lower by next Friday.
Adjusting the contract down to $0.16.
The Length of the Contract
Contract expiration dates should be kept short. Markus goes into more detail about how you should pick a contract end date. I think his approach is sound. His general recommendation is to pick an expiration date that is at least three days out and no more than nine days from today’s date.
In plain language, this means that if you are trading a weekly option, like HPQ, and it is Monday or Tuesday, then you want to have your contract expire this coming Friday, which would be 3-4 days out. If you are trading on Thursday, then you probably want to set your contract expiration date for the following Friday, which would be eight days until expiration.
Order Execution
The cash covered put trade was successfully completed. The following image shows the notification I received from Fidelity when the order was executed. The ticker symbol is a reminder of the nature of the contract. It contains the ticker symbol HPQ, the contract expiration date, the type of contract (PUT), and the contract price of $27.
Summary
The goal of this post was to illustrate another way to generate income trading options. The two primary methods I use are selling covered call options, and cash covered puts. The wheel strategy puts both of these together to gain even more income if there are no surprises.
Links for Learning
Learn more about the Wheel Option Strategy. Markus Heitkoetter Wheel Option Strategy Explained. He also has a Kindle book available on Amazon called “The Wheel Options Trading Strategy.” I purchased his book as a reference.
Know Your Flocks & Herds 