In the last several posts, we discussed options and why you should virtually never buy options. We also talked about how selling options can be a part of a value strategy, and why there are fewer situations than you think where option selling is the right thing to do for your long term investing success. Now, I wanted to discuss one final option selling strategy called the wheel, which is often used by value investors, and why this might not be as great of a strategy as so many investors think it is.
The wheel, is a strategy of selling cash secured puts on a stock for income. When one of these puts is exercised and you get assigned the stock, you then sell a covered call against the stock. You keep doing this until the call gets exercised and the stock gets called away from you. Then, you continue writing cash secured puts on the stock until you get assigned. Rinse and repeat. There are many details, which I won’t get into, such as methods to determine whether to write a call on the stock at lower strike prices if the stock declines while you own it and you end up with losses that are greater than the option premiums that you collect.
The wheel is touted as a relatively safe way to generate continuous income on your capital, and I see a number of value investors also utilizing this strategy. However, I will present some points here about why it is inferior to buy and hold investing. Let’s look at some examples to see some potential problems.
Example 1:
You sell a put with a strike price of $25 expiring in 1 month on ABC company which currently trades at $25. The value of the put is $1.00 (remember the option multiplier is usually 100 so you collect $100 up front). You now have $2500 in capital you must set aside to make this purchase ($2400 of your own plus $100 of option premium that you collected). You put this in a 1 month treasury bill yielding 4% annualized which gives you $8.33 in interest at the end of one month. At expiration, the stock trades at $24, so you are assigned the stock. You then sell a call with a strike price of $25 expiring in 1 month on ABC company. The value of the call is $0.70 (so you collect $70). At expiration, the call expires without being exercised because ABC is now trading at $15. Your position is now showing a loss of $821.67 ($100 put premium + $8.33 interest + $70 call premium – $1000 unrealized loss on the stock from price decline).
What do you do now? You can’t sell another $25 call expiring in 1 month on the stock trading at $15, since it is quoted at $0.01 and no one will pay you much for it. You could write a call with a strike price of $15 expiring in 1 month for $0.80, but if it gets exercised, you will be forced to sell the stock at $15/share for a loss (remember you paid $25 per share), and the option premiums won’t come close to covering the losses. You could also sell a $25 call expiring in 1 year for $1.00, but now you must have your capital tied up in the stock for a longer time. You cannot use this capital to wheel other stocks. Odds are, you will hold on to this stock for multiple years while it is depressed, then just as it is climbing up, it crosses your strike price and gets sold for small profits amounting to just the option premiums. The stock then continues upwards and you miss out on any capital gains.
Here is another problem example.
Example 2:
You sell a put with a strike price of $25 expiring in 1 month on ABC company which currently trades at $25. The value of the put is $1.00 (remember the option multiplier is usually 100 so you collect $100 up front). You now have $2500 in capital you must set aside to make this purchase ($2400 of your own plus $100 of option premium that you collected). You put this in a 1 month treasury bill yielding 4% which gives you $8.33 in interest at the end of one month. At expiration, the stock trades at $24, so you are assigned the stock. You then sell a call with a strike price of $25 expiring in 1 month on ABC company. The value of the call is $0.70 (so you collect $70). ABC company pays a dividend of $24 on your 100 shares of stock during the 1 month of time that you own it. At expiration, the call is exercised because ABC is now trading at $27. Your position is now showing a gain of $202.33 ($100 put premium + $8 interest + $70 call premium + $24 dividend + $0 capital gain from stock price changes).
In this example, at tax time, you pay the usually much higher short term capital gains rate and non-qualified dividend tax rate, since the holdings were short term. Repeated many times, this is so much worse than owning a stock for a long time and not having to pay any taxes on it at all as it grows in value, since you do not sell. You can utilize the money that would otherwise be paid in taxes to fuel more growth for your portfolio. As we discussed before, this is a major component of why buy and hold strategies work.
However, there is one nuance about wheel investing that is missed by most investors. If you invest in 10 stocks, a typical distribution of success will be something like this: about 2-3 stocks will be terrible to mediocre performers, 4-6 will be average performers, and 2-3 will be above average to stellar performers. We focus on only investing in quality stocks, so that we can skew this to greater success. If you follow a star list strategy of investing, where you develop a shopping list of the highest quality stocks and only buy the best values on that list, you should be able to skew your success rate more favorably. On a portfolio of 10 stocks, you might have 1 stock that will be mediocre, 4-5 that will be average, and 4-5 above average to stellar performers. While it might still seem bad that you would get 1 bad performer, the difference of eliminating just one bad performer and adding one stellar performer will make an enormous difference to the value of your future portfolio years from now.
The wheel strategy does precisely the opposite of quality investing. If you accept as a matter of definition that in the very long term, total return of stocks in good companies have a rising tendency, and stocks in bad companies have a falling tendency, then the wheel will tend to accumulate bad companies and sell good companies naturally. The reason for this is that over time, bad stocks will eventually trend downwards, so at some point your put options will get exercised. When you write call options, you may for a while be able to get out of the stock, but eventually, the stocks downward trend will tend to put you out of profit range and you will end up holding bad stocks. Similarly, for good stocks, the upward long term trend will tend to make you get out of those positions. Calls that you sold will tend to get exercised, and puts that you sold will not get exercised as frequently. Over time, you will tend to accumulate stock in bad companies, and lose possession of stock in good companies. While this won’t happen every single time you sell an option, the effects will accumulate over time and weigh on your portfolio. You won’t even know what those companies will be in the future, but the natural mechanics of the wheel will cause this to happen anyway. Eventually, you would need to sell the poor performers in order to remove the detritus from your portfolio, taking the losses that this entails. In addition, clipping the wrong end of the risk-reward tail during selling of calls that I described in the previous post, will exert a significant drag on any performance of the equities that you do see.
Because the wheel encourages shorter term holding, is less tax advantaged, and naturally tends to accumulate poor companies to your portfolio, you should avoid participating in this strategy. In addition, the relatively constant premiums you collect will be dwarfed by the performance of a truly great set of companies compounding to enormous profits over time.
To summarize the last few posts on options, you should generally avoid most buying and selling of options. The one scenario where it is worth it to sell an option is in the case where you have a great company that you want to own, but it is not quite in the price range where you would be willing to own it. In that case, you can sell a put option on the company at a strike price where you would be willing to own it. If the price falls into your range, you are happy to own it. If not, you collect the put option premium and move on to the next opportunity. This will give a small boost to your capital as you collect premiums, but won’t interfere with buying and holding, and won’t cause you to incur large amounts of extra taxes. Any other scenario where buying or selling of options takes place, in my opinion, is inferior to an outright buy and hold strategy where options are not involved.
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