It’s the clash of the titans: trading long strangles versus the options wheel. I started my options trading journey by selling covered calls, which is part of the options wheel.
Over time, I started selling cash-secured puts to lower my cost basis on future shares. Together, selling covered calls and cash-secured puts comprise the options wheel.
However, selling these “self-insured” products is expensive. It’s not fun having $20,000 stuck inside of tanking Palatir (PLTR) shares, as I once did.
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I began exploring ways to trade options with less capital and discovered trading long strangles. Both techniques, the options wheel and long strangles, have pros and cons, but I want to discuss the upfront capital you need to start today. Let’s begin.
Saving your capital. Don’t go into options trading unless you have a household budget. In fact, options trading is simply a way to budget your money in the options market.
For example, let’s say you have $2,000 in your options trading portfolio. You will only want to trade $800-$1,000 simultaneously. It requires discipline to become a powerful part-time options trader.
But how do you know how much to start with? I use my rule of 40 (the options wheel) and my rule of 15 (long strangles).
Multiply your desired monthly income by the rule, and you’ll get an estimate of how big your options trading account should be for each strategy.
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The rule of 40 for the Options Wheel. Let’s say we want to earn $1,000 in monthly options wheel (selling cash-secured puts and covered calls) premiums.
Using the rule of 40, we would need to have $40,000 in our options trading account. This gives us enough overhead to avoid trading all our cash at once. Let’s explore.
Assume we are selling SoFi Technologies (SOFI) cash-secured puts. SOFI’s current stock price is $15.94; therefore, we want to sell cash-secured puts at the $15 strike price.
We will earn $0.54 per share at this strike price, which means $54 per contract (100 shares). To reach our goal of $1,000, we would need to sell 18 cash-secured puts.
For each cash-secured put contract, we must have enough cash on hand to purchase 100 shares of SOFI at our chosen strike price, which in this case is $15.
To earn $972 in options premiums, we would need $1,500 per contract multiplied by 18 contracts, which equals $27,000 on hand.
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As you can see, the rule of 40 worked its magic again. It allows us to trade our cash-secured puts safely while keeping $13,000 out of play. However, it costs a lot of money.
Finally, let’s take a look at the yield we created—multiply $972 by 12 to get an annual amount of $11,664. Now divide $11,664 into $40,000 to get an annual yield on capital of 29.16%. Pretty amazing.
The rule of 15 for trading long strangles. Let’s look at the opposition. The rule of 15 will get us into the game much faster but at greater risk. Let’s take a look.
Let’s continue to trade long strangles using SOFI. The major difference is that you want to trade around volatile events such as earnings calls. It’s tough to trade long strangles monthly on one stock; therefore, finding at least three stocks across different months would be wise.
If we want to earn $1,000/month in strangles passive income, we would need $15,000 in our options trading portfolio.
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Let’s rerun the numbers. Each long strangle consists of buying one put option and one call option. Of note, I said buying, NOT selling.
When you purchase an option contract, it behaves much differently than when you sell one. You will need to understand how time decay affects each product. The best way to learn is to jump in with a small amount of capital.
SOFI’s share price is $15.94, so we want to purchase one call option at the $17 strike price and one put option at the $15 strike price. One complete strangle would cost us $122.
My metric for completing a successful long strangle is earning 20% on invested capital. Therefore, I want to earn $25 for each strangle.
To earn $1,000 in premiums, I would need to trade 40 strangles at $122 each. That would give us a total of $4,880 in invested capital.
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I wouldn’t recommend purchasing 40 puts and calls. To alleviate purchasing this many, you can set the expiration date much further, which increases the price of each.
This allows you to purchase fewer puts and calls but still spend $5,000. Now, let’s take a look at the annual yield.
If we find three stocks we can trade for each quarter, we earn $1,000/month. Multiply that by 12 months to reach $12,000 in annual premiums; divide $12,000 into $15,000 to see our annual yield of 80%. Yes, it is much higher than the options wheel.
Time to get started. We see that trading long strangles requires less upfront capital and can earn a higher yield, so why use the options wheel?
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In short, it is much safer. You really can’t lose money on the options wheel unless you have a constantly tanking stock.
As long as your stock bounces back every few months, you will continue to earn money on the wheel. The worst that can happen is that you won’t be able to trade because your cost basis is too high compared to strike prices.
Conversely, you can lose money trading long strangles because of time decay, reduced volatility, and flat stock movement.
Purchasing call and put options is like holding a hot potato; the longer you hold them, the hotter they become.
As you approach the expiration date (starting about two weeks out), time decay ramps up. It can cause you a lot of stress.
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I recommend that everyone start by selling covered calls and cash-secured puts. This strategy will teach you the basics of options trading.
You don’t need to build your $40,000 portfolio to start. Currently, you can sell one cash-secured put on SOFI for $1,500 at the $15 strike price. That trade would earn you $55—an annual yield of 44%.
Conclusion. I will explore the emotional side of trading in future articles in the series. However, it’s a good idea to start by looking at the options wheel to understand how things work.
Options trading is unlike anything most people have done. It is highly emotional and irrational. Most times, you cannot explain how short-term stock prices move.
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Eventually, you want to be able to sell two monthly cash-secured puts on a stock, and one long strangle for its earnings call.
However, this plan falls apart if the market assigns you shares. Now, you hold a portion of your capital in hundreds of shares.
I use both techniques to earn small monthly incomes. I do not want to invest $40,000 in options contracts; I would rather earn $200 to $400 in premiums.
However, you must decide how far you want to go. The more you know about your stocks, the better you can judge how much to play. Be warned that some of these things are completely random.
You’ll never know how an earnings call will affect your stock, even if they beat on expectations. I guess that is part of the “fun” of options trading—you never know what you’re going to get. Good Luck!
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