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 leaner than the 30% or even 60% returns that some options trader 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), 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 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 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.
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The post Why the Wheel Strategy Doesn’t Work – Options Series Part 12 appeared first on Early Retirement Now.