Investing 101
How to Use the Wheel Strategy to Generate Synthetic Dividends
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Learning how to utilize the wheel strategy to generate synthetic dividends is a strategic move for investors looking to enhance portfolio efficiency. This options investment strategy is designed to secure additional revenue in the form of passive income on top of dividend payments, particularly during sideways markets. Here’s what you need to know.
Summary
The wheel strategy is an options-based income approach that uses cash-secured puts and covered calls to generate recurring premiums. By rotating between these positions, investors can create synthetic dividends, lower their cost basis, and produce steady income in sideways markets.
What Is the Wheel Strategy in Options Trading?
The wheel strategy is a common investment technique that enables traders to manage risk while securing passive revenue. In its simplest form, it refers to a trading method in which you utilize collateral to secure premiums. Specifically, you sell (write) covered calls and cash-secured puts. This strategy is popular because it allows you to collect premiums regardless of whether the stock is ultimately bought or sold.
To gain a deeper understanding of the wheel strategy, you first need to look at why it was created, the assets it utilizes, and how it has adapted over the years. The wheel strategy revolves around the use of options. Stock options are contracts that provide the holder with the right to purchase 100 shares of a stock at a preset price.
Notably, options are not an expressed agreement to purchase the stock, but rather an option to do so, if the buyer decides it’s in their best interest. Investors bet on the price of these assets using calls and puts. Calls are seen as bullish bets, whereas puts are bearish bets.
Premiums
Premiums are what the option buyer pays the seller (you) upfront to secure the options contract. The premium value is derived from the intrinsic value (what the stock is worth currently) plus the time value (the time left before the option date expires).
You can think of premiums as a non-refundable deposit. If the buyer doesn’t exercise the purchase option, the seller keeps the deposit. Notably, premiums can increase during times of volatility, representing the potential for bigger price movements.
This higher premium directly benefits sellers and opens the door for the use of the wheel strategy to generate additional revenue.
Why the Wheel Strategy Works for Income Investors
The wheel strategy is a highly effective way for investors to generate passive income during a variety of market conditions. The main components of this strategy revolve around the use of collateral. There are two types of collateral you will need to complete this maneuver.
The first piece of collateral you will need to complete the wheel strategy is cash. You need enough liquid capital to cover the cost of purchasing 100 shares if assigned. Eventually, if assigned, you will hold 100 shares of stock. It’s recommended that you use a stock that is reputable to prevent losses due to the stock plummeting to near-zero value during your wheel strategy execution.
Covered Calls
You need the 100 shares because that is the minimum required to qualify for covered calls. The right to purchase these shares is then sold as an option, with the buyer paying you the premium upfront to lock in the contract. The term “covered call” refers to the fact that you possess the 100 shares already awaiting sale, as opposed to a “naked” call where you do not own the underlying asset.
The Strike
The term “strike” refers to the price point you would be comfortable selling your shares at (for calls) or buying them at (for puts). The goal is to select a strike that is reasonable enough to entice buyers but allows you to manage assignment risk effectively.
This strategy is ideal because it locks in some capital gains even if the option is exercised. However, the ideal situation for income generation is that the strike isn’t hit and the buyer never exercises their option, leaving you with the premium and the asset. This allows you to write another option, secure more premiums, and so on. If done correctly, it’s common for investors to generate returns that significantly exceed standard dividend yields.
Step-by-Step Breakdown of the Wheel Strategy
Swipe to scroll →
| Step | Action | Capital Required | Income Source |
|---|---|---|---|
| 1 | Sell Cash-Secured Put | Cash for 100 shares | Put premium |
| 2 | Get Assigned Shares | Shares purchased | Lowered cost basis |
| 3 | Sell Covered Call | 100 shares | Call premium |
The goal of the wheel strategy is to utilize the options to create a passive income engine without creating enormous risk. It involves revolving between cash‑secured puts and covered calls on stocks in a manner that creates a loop, or wheel, that generates recurring premium payments.
The first step of the wheel strategy is to sell a cash-secured put. The strike price of this put should be placed around 10-15% away from the current value (depending on volatility), or at a price where you are happy to own the stock. Be aware that you must be prepared to buy those shares if the option is exercised.
If the stock price is above the strike at expiration, the put will expire worthless. You keep the premium, and your cash collateral is released. You can then repeat the process. If the price is below the strike at expiration, you are assigned the shares (you buy them). Once you own the shares, you switch to selling covered calls.
This action enables you to restart the cycle again, leading to its name, the “wheel strategy,” referring to the repeatability of this technique. If done correctly, the wheel strategy brings some significant benefits to the market. However, there are some key details you should take into consideration.
Key Risks and Mistakes to Avoid
Ideally, you will want to only use highly liquid, reputable stocks that have moderate positioning and sufficient implied volatility. High volatility increases premiums, but extreme volatility increases the risk of the stock dropping well below your strike price.
Notably, you should never assume that the option won’t be exercised. As such, don’t use stocks that you do not want to own. Also, be cautious with stocks on which you have large unrealized capital gains; if called away, you will trigger a tax event.
Wheel Strategy Benefits
While the wheel strategy is a bit more complicated than traditional buy-and-hold investing, it provides a host of benefits that have made it a staple in the trading community. For one, it enables you to lower your effective cost basis. Every premium that you collect lowers the overall net cost you paid for the asset, potentially leading to higher returns over time.
Additionally, the wheel strategy can provide more consistent revenue, especially during sideways market movement. Remember, this strategy specifically sacrifices high upside potential for consistent returns. These 1-2% monthly returns get compounded to improve overall results.
When to Use the Wheel Strategy
There are several market conditions where the wheel strategy is an advantageous option to consider. Primarily, it’s used during sideways or moderately volatile markets. The key is you want the market to have enough fluctuation to make your options premiums attractive, but not so volatile that it creates extreme value shifts.
In a sideways market, you can use the wheel strategy to secure additional revenue off of premiums. Notably, this approach isn’t ideal in strong bull markets because your covered calls will cap your upside. It’s also not the best during sharp declines, as you may be forced to buy falling stocks. However, the premium payments can help to offset the losses.
Keep it Short
The wheel strategy works best with short expiration dates. These dates are usually 30-45 days out. At this time frame, the time-decay (theta) of the option accelerates, working in your favor as the seller.
Writing Strikes
A key rule is to be careful when writing call strikes below your cost basis. If you do and the shares are called away, you will lock in a realized loss on the stock itself. Ideally, you want to sell calls at a strike that allows you to profit on the stock sale, in addition to the premium collected.
Taxes
Premiums collected from expired options are typically taxed as short-term capital gains, regardless of how long you intended to hold the position. If an option is exercised, the premium is usually incorporated into the cost basis of the shares, affecting the eventual gain or loss when the stock is sold.
Tax treatment can vary based on jurisdiction, account type, and whether options are closed, rolled, or assigned. Because option taxation can become complex, investors using the wheel strategy should consider consulting a qualified tax professional before implementing it at scale.
Potential Risks
You should understand that puts and calls leave investors exposed to downside risk. Specifically, puts can lead to assignment during downward markets, resulting in paying a higher-than-market price for stocks. Conversely, calls place a cap on your gains during bull markets. As such, these strategies are seen as a trade-off: capping upside potential in exchange for consistent premium income.
Use Tools to Improve Results
There are several tools designed specifically for investors conducting wheel strategies. These options include vital data like automated trade alerts, complete puts/calls listings, risk assessment tools, and wheel-specific scanners.
Example of the Wheel Strategy
Here is an example of the wheel strategy using TESLA (TSLA) at $477. Note: this stock is generally more volatile, but its company is established and in high demand, making it suitable for this example. The first step is to sell a cash-secured put for $460 with a 35-day window, creating an $18 premium per share, equaling $1800 total.
If TESLA share value remains over $460 at the expiration date, you keep the $1800 paid by the buyer to secure the contract and repeat the cash-secured put strategy, securing premiums until your option gets assigned. If assigned, you buy 100 shares at $460 each. Since you collected $18 per share in premium, your effective cost basis is $442 ($460 – $18).
The next step is to sell a covered call for $500 on the shares you just purchased, creating a $22 premium equaling $2200. If TSLA remains under $500 per share, you retain ownership of the shares and the premium, further lowering your real cost per share.
If the call is assigned, you sell the shares at $500. In this scenario, you profit from the capital gain on the stock plus the premiums collected from both the put and the call.
Best Platforms for Running the Wheel Strategy
It’s crucial that you stick to platforms with lower commissions and established reputations. You don’t want to eat up your profits due to fees and hidden costs. Additionally, you don’t want to suffer losses because of technical issues on the side of the exchange. Here are some popular options:
Thinkorswim
Thinkorswim launched in 1999 to provide advanced trading options to the market. The company’s founder, Tom Sosnoff, realized a growing demand for more powerful trading tools early on. His team and strategy saw immediate success, leading to a $606M buyout from TD Ameritrade in 2009.
In 2020, Schwab acquired TD Ameritrade, furthering the platform’s reach and products. This led to an eventual rebranding in 2023 as Schwab Trading Powered by Ameritrade. Today, the platform is known as Thinkorswim. It provides customizable scans, charting tools, backtesting, options, and probability tools that are specifically designed for investors using the wheel strategy.
Interactive Brokers
Interactive Brokers remains a pivotal service provider in the industry. The company launched in 1977 as T.P.&co. In 1982, it was renamed to Timber Hill Inc. before changing its name again to Forms Interactive Brokers in 1993. Notably, the platform was one of the first to integrate electronic trading.
Since its launch, Interactive Brokers has retained its pioneering spirit. It has consistently introduced new products, trading algorithms, and strategies to help investors. It has also been instrumental in advancing desktop trading protocols, including wheel scanner-specific options.
Interactive Brokers is a popular platform because it supports full automation. Traders can program their trading activities using popular coding languages like Python. Additionally, it supports full API integration, opening the door for third-party trading bot strategies.
Investor Takeaway
For disciplined investors with sufficient capital, the wheel strategy can enhance returns without chasing price appreciation. However, it caps upside and requires strict risk management, stock selection discipline, and awareness of tax implications.
Is the Wheel Strategy Right for You?
The wheel strategy has come a long way over the last few decades. Today, it’s seen as a reliable way for professional traders to reduce risk while improving their ROIs. The combination of additional wheel strategy tools and platforms that support the maneuver has made this investment technique more attractive than ever.
What do you think about the wheel strategy? Would you use it to improve your ROIs? Like, comment, and share your thoughts, and don’t forget to click here for more investor tips.
