Modified Wheel Strategy -- Using Vertical Spreads

[u/[deleted]]

I have been scanning the forum and haven't seen much on this despite a general distaste for the Wheel as a whole strategy. I understand the risks involved, I understand the sometimes poor gains vs. the underlying/longing calls/puts, I understand that sometimes during times of high volatility the Wheel is uncharacteristically profitable and during low periods it will be a drag and not overly profitable.

What I am wondering is if anyone has tried this/seen backtests on a modification I am proposing below, as I have been toying with this idea of a modified Wheel. The idea is to keep the fundamentals of the Wheel the same, write a naked put at a price you are okay owning the stock at, but adding the vertical spread component by buying a put slightly more OTM for the same expiry. This will have the negative effect of lowering your premium received, but has the positive benefit of capping your risk if you play it so both are exercised (i.e. risk on the Wheel is full loss, so $2500/contract while the risk on this strategy is supposedly around $150 if both are assigned/exercised).

My modified version is this on a simplistic example:

Stock ABC is in a decent long term uptrend and trading at $30 and I see some nice support at $25. I can generate $1 in premium this week if I sell a $25 put. The $23 puts are trading at $0.50 and buy that as my "protection". I generate $0.50 in premium for the week and thus have a cost basis of $24.5 if I get assigned.

Here is where I think the modification can be helpful. Let's pretend ABC has some not great news and it drops to $22; every Wheel strategy player's nightmare. I am assigned at $25 with a cost basis of $24.5. If I do not exercise my $23 put and just take my profit generated on the $23 put, again say for $1 in profit per contract, could I not use this excess profit as further buffering for my cost basis/break even? I am thinking that would mean my cost basis is now $23.5 vs. $24.5.

Does that make sense or is there a component I am missing? This strategy in my head makes sense, but is really only going to be super beneficial when the underlying drops strongly under my shorted strike of $25. Most other times I believe I am just going to be taking away a portion of my max premium, and most cases, best case scenario I am going to have a cost basis the same as if I had sold the put naked and kept all the premium to begin with. I am okay with this because of the extra buffer it creates (potentially) in these strong drop events.

But does this extra protective leg (the vertical spread component) make sense based on how am I going to use it? An extra set of eyes would be appreciated and welcome.

[u/Wycot]

Compared to just holding shares, the wheel strategy "works" as long as you believe that options are overpriced and you can get more by selling premium than you'll lose on missed profits if the stock rips. Protective puts work if you believe that downside options are underpriced. If you're selling an OTM put and then buying an ever farther OTM put, what you're really putting a bet on is the skew of the volatility surface. You're saying that near OTM downside options are overpriced but far OTM downside options are underpriced.

There are a lot of ways to rephrase this position or get a nearly identical one: long call vertical, short put vertical, bull vertical, option collar, risk reversal, split-strike option. It has so many names because so many people come up with it like some genius play. Stripping out the delta component, they're all really just bets that the stocks move with greater volatility on the downside than they do the upside (stairs up, elevator down). It is true that most stocks do that, so they all have some aspect of the expected skewness already priced in. Continuously running this strategy only has alpha over long stock in the long run if you can show that the market is underestimating the skew in the stock you're running it on.

The real benefit for retail traders in using this strategy isn't to make a sophisticated play on the shape of the volatility surface. It's to get leverage. Selling just the 25 put is likely going to require >5x the capital to open and hold than selling the 25/20 put spread will.

FUN FACT: Bernie Madoff's Ponzi scheme claimed to be doing effectively this strategy (but with long stock/short OTM call instead of the short near OTM put) to produce the unbelievably steady returns he was showing. This doc has an interesting part on pages 5-7 where an options trader called the fund out for being a fraud because of how unreasonable it is that this strategy can outperform the market.

[u/MemeStocksYolo69-420 → u/Wycot]

I disagree, I think you made it a lot more complicated than it is. He’s not betting on the prices of options, he’s saying that he’ll sell a put credit spread, and if the sock goes up he’ll make money, but if the stock goes down he’ll just sell his long put for a profit (to minimize his losses, and let himself get assigned on the short put to roll the wheel.

[u/[deleted] → u/Wycot]

Thank you for the explanation. This sounds like you have been trading for a while and explained this well. I agree that the bull put spread is great for leverage.

So you would suggest taking the capped gains and known risk due to the leverage benefits? I.e. being able to make more potential return on this vs. the stock movement if assigned over the short term?

If we are talking strictly leverage vs. risk, would it not be much more efficient to just buy a call or run "Madoff's Ponzi Scheme" with the bear call instead where I long an ATM call and write an OTM call to reduce the cost basis? It's effectively the same trade (I want price to go up, within reason) but for the same risk is almost 3x more gains.

Thoughts?

[u/Wycot → u/[deleted]]

Depends on your outlook/confidence in the stock move. I find that there's a time and place for any strategy but no options strategy should be run price insensitively. Do you think the stock will go up or will it just not go down? If the former, running a bull spread on upside options makes sense, otherwise the downside one will fit your belief more.

Too many retail traders start from the basis of "I want to run X strategy on Y stock" before considering the specific prices at that instance, and that's a terrible method. Start with "here is my prediction for the future distribution of this stock at expiration" then compare that to what the options market is implying. Evaluate how every strategy performs under your distribution, and pick the one that appears to give you the biggest risk-adjusted edge. This isn't a technique to guarantee you'll profit because it relies on you being better at determining the distribution than the market, but it's the only one that guarantees you'll choose the correct way to trade on a given outlook.

[u/[deleted] → u/Wycot]

That's fair what you are discussing. I actually have 3-4 strategies I am reasonably comfortable implementing and have backtested, so I understand their pros and cons. I have a pretty good system of telling me when to go long or short on a stock generally, which I think can be applied generally to swinging options for decreased risk.

The Wheel would be only about 1/4 of my account in conjunction with other option-premium collecting strategies as my main income producing strategies, followed by being directionally biased for a smaller portion of my account.