Note that When it comes to The Options Wheel Strategy, People refers to many variation. This variation discusses the most simplest one which tells to rotate the wheel for one time only.
Although our suitable candidate for discussion is SunTV. Let’s discuss this with BankNIFTY.
In Part 3, You learned Your first step which is “Picking a stock or index”.
Also, Only pick a stock that you are bullish on, or think will rise in the long term.
We are discussing parts that are like “digestible chunks” before We come to the main part. In Theta, We used to do – Slow Turtle
Sales growth 5Years < 10 AND
Market Capitalization > 50000 AND
Average return on equity 5Years >15 AND
Price to Earning >10
First, We shall discuss the strike price.
There are three rules –
Rule 1: Your premium should be at least 1% of the stock’s price.
Rule 2: Wait for a “down” day.
Always remember, You know IV is high because the option’s price is high. Not the other way around.
The more the fear of fall, the more the premium price, the more the IV.
Confusion Alert: So, if We talk Price of options will be high because of IV. It is a wrong statement but You will pardon it because that’s the norm.
One of the other primary reasons to hate to start this strategy on a day when the market goes up too high, the difference between the premium of the futures and the spot gets more high.
Also, As You are going to sell put options, You profitability is limited too. What if the scrip rises 10% ?
Anyways, Let’s do with Biocon –
The lot size of Biocon is
Cash Needed for buying
2300 Biocon shares
= 2300*382.5 = 879750
Note – By “Cash Covered Put”, It is meant that You should be able to take the delivery of the shares if the breakeven of the Put options is breached. So, It will need minimum 9L of margin.
Let’s find our strategy reverse-wise from Rule 1: Your premium should be at least 1% of the stock’s price.
1% = 8797.50
20% cost of brokerage and slippage, let’s make it
1.2% = 10557
Let’s have a look at the Biocon on the NSE website.
And find the PE strike price which has a premium of
10557. It will be priced at
1.2%in a month.
So, select the next month’s expiry
Rule 3: Check the illiquidity of the Strikes.
365. We can see from the bid and ask of
365PEnext month’s Biocon that it is illiquid.
Here is an illustration with Biocon June Puts and their Bid and Ask that will show you clearly the case of illiquidity –
Anyways, We can tweak with Rule 1.
Step 3: Repeat until Loss (edited)
If the option expires worthless, Repeat the same thing in the next month.
But, there are a few complications in the Indian Stock Market as We write this article.
Now, Do you understand What do I mean by “Considering that premium in the next month’s strike selection?”
What if the option does not expire worthlessly and ends in unlimited loss? This will become tricky and mathematical next.
Let’s look at a theoretical example to see exactly how the strategy works when the option does not expire worthlessly.
Let’s assume Biocon ended in 360.6 in the June expiry. In this case, there are two ways –
If We see Biocon May
8.75 while Biocon trading at
382.5. It is quite good to exit because the breakeven of the
390PE here is
So if we hold till expiry and Biocon stays at it is where We will gain
382.5-381.25 = 1.25.
2875 INR in
879750 INR is approximately
0.33%. It is insignificant.
If it is insignificant, You can add this premium to the next month’s strike’s premium i.e. choose the next month’s strike with
1.25 more premium in it.
If it is significant, it is time to “turn the wheels”.
Now, it will look complicated if We discuss the “turn the wheels” part of this strategy factoring in the “early exit” in options before the margin expansion.
So, Let’s assume, Biocon ended in 360.6 in the June expiry.
Our Net Loss right now is
(362.4-360.6) = 1.8 points which translate to
1.8*2300 = 4140 INR. Right?
Now, Let’s “turn the wheels”.
Time to sell a call option and make it a covered call.
Now, Note – The cost of a covered call is considered free because You will get the margin by pledging the shares.
Even with its worst haircut, if the stock is selected from our stock selection criteria, the haircut will be good. (Haircut = Term used for pledge system. Dabur has a
20% haircut means if You have
100 INR worth shares of Dabur, You will get
80 INR instantly the moment You pledge it.)
Your breakeven point is
Sell 370CE or Sell 380CE or Sell 390CE.
For a more methodological way, You can see if the premium of that strike is more than 1% like You were checking while selling put options.
Now if the stock is consolidating in the same place for a long time, it will be awesome. Like, As We are speaking, ITC is more or less being traded at 200 and has not been impacted in the stock market crash induced by Corona Virus.
There are even memes coming out –
It will work wonders in cases of stocks like this.
Also, in the selection of covered calls, We can summarize choosing the strike price like –
Select the strike price –
Now, With each profitable iteration of the “Covered Call” setup, Our BEP decreases! (We are not referring to the Break-Even Point of Covered Call but the whole system itself.)
Suppose We had sold
5 and it became
0. Our breakeven point is reduced from
(362.4-5) = 357.4.
So, Summarizing –
Step 1: Picking a stock or Index
Step 2: Sell a Cash Covered Put
Step 3: Repeat until Loss
Step 4: Construct the Covered Call
The moment You come to profit by doing this covered call method which is –
Congratulations, You have turned the wheel.
Just Jump back to the First Step and Sell Put again.
Cash Needed for buying
2300 Biocon shares =
2300*382.5 = 879750
Margin needed to buy Biocon June Future @
238288.05. You can see that here –
The premium of Biocon June Future
3.6 points ~
8280 INR is sort of interest for 1 month for
879750 - 238288.05=641461.95 INR right?
1.29% per month.
The Devil is in the details.
Now, Let’s construct this –
You should be aware of “Premium of Futures” and “Synthetic Futures Construction” because sometimes You may get a sweet deal from the devil too. Right?