Tiblio AI seeks to generate steady cash flow by selling covered calls and puts on equities. It follows the ever popular Wheel Strategy. However, not all equities are created equal when it comes to implementing this strategy. In this article, we discuss the key factors investors should consider when selecting equities to trade options on using the Wheel Strategy. By understanding these factors, investors can identify equities that are best suited for the strategy, potentially improving their chances of success.
Here are the key factors that investors should consider:
Options on stocks with high trading volume tend to have tighter bid-ask spreads and provide better pricing for both buying and selling options. Therefore, it is important to select equities that are highly liquid, which means that there is a significant amount of trading activity and liquidity in the options market.
Steady Price Trend
The wheel strategy works best on equities that have a steady price trend. Stocks with extreme volatility or erratic price movements may not be suitable for this strategy, as it can be difficult to make up losses with the option premium.
A company's financials, such as its revenue growth, earnings, and cash flow, play a crucial role in determining the stock price. Therefore, it is essential to select equities with strong fundamentals, as these companies are more likely to perform well in the long run. This is especially important now in the beginning of 2023 as it is very possible that the US has already or will enter into a recession.
Moderate to High Implied Volatility
Implied volatility is a measure of the expected future volatility of an underlying asset. Options premiums tend to be higher for equities with higher implied volatility, which means that investors can earn more income by selling options. However, too much volatility can increase the risk of the trade, so investors should select equities with moderate to high implied volatility.
Sufficient Margin of Safety
The wheel strategy involves selling options contracts, which exposes investors to potential losses if the stock price drops significantly. Therefore, it is important to select equities that have a sufficient margin of safety, which means that the stock price is not significantly overvalued and has a relatively low risk of significant price drops.
Dividend paying stocks can be really good for the wheel strategy because they offer another source of income for the investor and because they are typically held by large institutional investors, they tend to be more stable than non-dividend paying stocks. Investors should research the dividend and ensure that there is no short term risk of the dividend being cut or reduced as this could cause a significant drop in the stock price.
Here’s an example of what not to do.
Consider Gamestop (GME). The stock is exciting to trade in the short term. However, investors tend to experience huge price movements to the upside and downside. These price movements do not work well with the Wheel Strategy and will cause the investor to lose out on the big upside gains and suffer the big downside losses.
In summary, selecting the right equities is crucial when implementing the wheel strategy for options trading. By considering key factors such as liquidity, price trend, fundamentals, implied volatility, and margin of safety, investors can identify equities that are well-suited for the strategy and potentially improve their chances of success. However, it is important to note that no investment strategy is foolproof, and there is always a risk of loss. Therefore, investors should conduct thorough research, understand the risks involved, and only invest funds that they can afford to lose. With the right approach and mindset, the wheel strategy can be a valuable tool for generating income from the stock market.