How to Convert a Short Put into a Covered Call
Aug 9, 2023
Looking for a way to buy stock at potentially lower prices—while also participating in the upside in the meantime?
Check out the wheel strategy!
The wheel strategy consists of an out-of-the-money (OTM) short naked put, used as a way to take shares at a potentially lower price. If the option expires in the money (ITM), you could then wheel into covered calls (selling an OTM short call against the now long shares of stock). This strategy collects extrinsic value premium on both sides of the market—reducing basis and risk.
Let’s say, for example, the stock trades at $100
Selling the 92 strike put for $2 in premium.
If the stock were to fall to 90, the stock position would be at a loss of $1,000 vs. the short put loss of $800.
Say we took stock via that short put and wheeled into a new covered call position with a strike back at the $100 high for $1 in premium. We’ve now collected $3 in total premium, which brings our breakeven price all the way down to 89. If the stock rises back to $100, we’d profit $1,300 on the total trade!
The caveat here is that a short naked put has capped upside potential. If instead the stock had gone to $120, the profit of the position would be $2 vs. $20 of upside on the long stock position.
The wheel strategy is applicable to any account type. But the capital required to hold the position differs depending on the type of account. In a margin account, traders receive roughly 4:1 leverage vs. the cash secured risk. Take, for example, a short put at the $100 strike would use around $2,500 in BP (with the notional value being $10,000).
In Cash/IRA accounts, all naked positions are secured to the notional value—so in this case, the short put would use the same about of buying power as 100 shares of stock. In these accounts, we consider buying a far OTM long option just to reduce the capital required to hold the position. The long put will greatly increase return on capital (ROC) and efficiency of capital used to hold the position for just a small debit.
The wheel strategy is a staple for IRA account traders because it allows for reducing potential cost basis, while also adding a time decay component with the potential to increase forward gains.
Nick Battista, tastylive director of market intelligence, has a decade of trading experience. He appears Monday-Friday on Options Trading Concepts Live. On Wednesdays, he co-hosts Johnny Trades. @tradernickybat
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