Wheel Strategy Risks: What To Do If The Market Crashes

   

When trading The Wheel Strategy, there will be the opportunity for tremendous gains. As with any trading strategy, there will also be risk that your trades could turn into losses as well. 

One example I always look at is: What to do if a stock you own suddenly tanks and you can’t sell against it? 

How about this one: What do you do if the entire market crashes and now you’re stuck with five positions and you can’t sell covered calls?

I get these questions all the time and I even ask them myself. So today, we’re going to talk about three very specific examples of trades that I’m in right now. This way, I can avoid getting in trouble if the market suddenly takes a turn. 

But first, let’s do a quick review of The Wheel Strategy so we’re all on the same page!

The Wheel Strategy In A Nutshell

The Wheel Strategy consists of three main steps: 

  1. First, you are selling put options and collecting premiums.
  2. The second step doesn’t always happen, but it can. If the stock price dips below the strike price of your puts, you might get assigned. Don’t worry, it just means you have to buy those shares at the strike price.
  3. The third step only happens if you get assigned. You sell covered call options on your assigned shares for more premium, until your shares get called away. At this point, the Wheel has turned full circle.

Now let me give you a very specific example of a trade I am in with The Wheel Strategy. In this chart we are looking at Nordstrom stock or JWN.

JWN strike price of 30
JWN strike price of 30

In the first image, I was selling put options with a strike price of $30. See the line I drew at the $30 line? That was acting as a good support level to sell puts for. This was great when JWN was trading sideways. 

You can see the point at which JWN dropped off below the $30 line. When this happened, I was assigned those shares at a strike price of $30. 

At some point there it was trading around $26, and now it’s trading at around $24. I’m going to talk about the $26 price level because that is where I made my trades for this scenario.

Let’s talk about three specific scenarios for this trade. 

But first, before we continue, this article is a part of our Options 101 For Beginner Series. This is a series of FREE on-demand video courses where you will learn the building blocks of options trading, the core concepts, how to avoid crushing mistakes, and much, much more. You can check out this free course HERE.

Scenario 1: What If The Stock Drops Around 20 Percent?

So when I first entered this JWN trade, the stock was trading at around $31 per share. From $31, went down to as long as $26, which is about an 18.6% drop in price. So what do we do when the price of the stock suddenly falls by about 20%?

Big drops for stocks can happen after you get assigned. At this point, the stock has already fallen below the strike price so you can assume a big drop took place. 

The next step is to sell covered call options above the assigned price if you can. So for JWN, I would sell the calls at above the $30 assignment price. 

JWN sell calls at 30 or above

Since the assignment price is at $30, I would try to sell calls at $31, $32, $33, you get the picture. 

Here’s what I did as we were dipping back down.

Wheel Strategy Risks

At first, the stock dipped to about $29. From here, there was enough premium to sell the $30 covered call options. This is Step 3 of The Wheel Strategy: Collecting premiums from covered calls. 

Eventually, you might reach a level where you cannot get enough premium from your $30 calls. What do I mean by getting enough premium?

This is all up to your personal trading strategy and goals. Personally, I like to make at least 30% annualized on the covered calls that I am selling. 

If it’s less than 30%, then I simply won’t sell the calls. But remember, 30% is my threshold, not yours. Your style and goals might differ from mine, and that’s okay! 

Just know that when I talk about my trades and collecting premium, I am expecting to make at least 30% annualized. 

Scenario 2: What If I Can’t Get At Least 30%?

Naturally, this is the next question: What if I can’t get the annualized 30% from collecting premiums?

Since premiums are affected by the price of the stock, there’s nothing you can really do. This is called a moment to just sit on your hands and do nothing. 

And for this trade, that is exactly what I did. I didn’t do a thing with JWN until the stock price moved back towards my strike price. 

Wheel Strategy Risks

So on my JWN trade, I’m down about $1,800. But in the meantime, I’ve been able to collect about $10,000 in premium from selling puts and calls. 

If I were to close this trade at that point I would have $8,500. But that’s just the loss on the trade. I’ve already made much more by selling premiums to offset that loss. 

Overall it’s not a bad scenario. I was assigned when the stock was tanking, but I’ve been able to sell calls on it multiple times since then! 

What If The Stock I Sold Puts On Tanks?

This is another very real possibility. If the stock tanks by 15-20%, you can sell covered calls on the shares you were assigned. 

But what about a scenario where the stock falls by 30% or more?

Luckily for you, I have a trade for the stock Las Vegas Sands (LVS) that shows this. 

Here’s a look at the weekly chart for LVS:

Wheel Strategy Risks

As you can see on the chart, LVS has been trading mostly in a range between $50 and $70. 

Wheel Strategy Risks

I decided to sell puts with a strike price of $58. But wouldn’t you know it, LVS kept dropping and it dropped to as low as $36. 

So how much of a drop is this? This is a $22 drop in stock price and from our strike price of $58, that’s a 38% loss. So what do we do now?

Follow Your Plan

Of course, this depends on what your trading plan and strategy is. As you can see above, I followed my plan. In the case of a 38% drop in stock price, I like to fly a rescue mission!

Flying Rescue Missions

I know it sounds adventurous, but flying a rescue missing really just means dollar-cost averaging as the stock price falls. 

Once the stock price dropped by 30% for LVS and it was around $40, I flew in my rescue missions. 

Before I continue, if you want to watch a cool video I made on rescue missions, check it out HERE.

So while dollar-cost averaging usually means buying more shares at a lower price, my rescue mission is selling more puts at a lower level. The goal here is to collect more premiums. 

If the stock continues to fall, I’ll be assigned more shares and that’s okay because I’ll sell more calls to make more premium.

One rule I follow in my rescue missions is the rule of one-thirds. For LVS I originally sold 60 put contracts, so in the rescue mission, I would sell in batches of 20 puts.  

Wheel Strategy Risks

For LVS, I was hoping the stock would make a near-term bottom and it did, at around $38. 

Once it found the $38 level, I started to sell puts again at $37 for one-third of my original size. 

Unfortunately, it did continue to drop below $37, so I was assigned some additional shares. But, due to the magic of dollar-cost averaging, my cost basis dropped from the original of $58 to my current average of $51.42. 

Since we’re nowhere near being able to sell calls for these shares, I continued to sell more puts at these levels. 

Wheel Strategy Risks

So, as we continued, LVS made new support levels at around $35 to $36. I have been selling one-third of my original position in puts, and this is what it looks like in the P&L after all of these trades and movements. 

Wheel Strategy Risks

The Results for LVS Trades

Here we have LVS and you can see I’ve collected a total of $7,175 in premiums. But for the stock trade, I’m down by $29,611 which isn’t great. If I were to close this position, I’d have a realized loss of $22,486 which is a 38% loss. 

So the first scenario with JWN, the stock dropped 15-20% and it wasn’t a major problem. 

But once we start dropping by 30-40% like with LVS, that’s when I needed to fly a rescue mission. It basically means I’m selling more premium and waiting for the stock to come back up. 

My Trading Account Size

One thing we have to keep in mind is that the account I am trading in is a larger account. I know there’s been some discussion about what the actual size of an account is. Initially, I deposited $250,000 which gives $500,000 in margin. But because of the portfolio margin, I had a total buying power of $1 million. Confusing right?

So here’s the story. On January 11th of this year, I opened the account with $250,000. It was a margin account, which gives me a total buying power of $500,000. 

Is that officially a $500,000 account? Not exactly, but I call it that because in reality, that’s how much I can invest. You get the idea! I just wanted to be transparent and put this all into perspective for you guys.

If I realized a loss of $22,000 based on my initial equity of $250,000 then that’s an 8-9% loss on my original investment. 

So those were the first two scenarios with the Wheel Trading Strategy, and I promised I’d talk about three. I’ll also explain to you what happens if all of our positions get assigned. 

Let’s recap here:

The first scenario was when JWN fell by 15-20% and the second scenario was when LVS fell by 30-40%. 

Now let’s talk about the third scenario: what happens when the stock keeps tanking?

The Infamous RIDE Trade

Now I’m going to talk about the infamous Lordstown Motors (RIDE) trade. Let me show you what happened here. 

I entered this trade initially in February of 2021 and I’ll be honest, I violated my own rules. 

RIDE

With RIDE I sold put contracts with a strike price of $21.50 when RIDE was trading for $24. When I say RIDE kept falling, I mean it kept falling. Right now, at the time that I write this, RIDE is trading for $1.64 per share or about 95% lower! 

Scenario 3: What Do You Do When The Stock Is Down 80% or more

First of all, I’ll say that RIDE did not fall by 95% right away. At first, RIDE only fell briefly by about 15-20% like in our first scenario with JWN. 

So what did I do? Just as with the other trades, I started to sell calls on the shares I was assigned. Remember, it’s all about collecting those premiums!

But then, RIDE just kept falling and soon I was in the second scenario like with LVS. The stock had fallen by more than 30-40%. So of course, I flew in my rescue missions. My cost basis was down from $21.50 to $15.79, and then eventually to $12.86. But then RIDE just kept falling! 

With the stock down 80% now from my entry point, what do you think I did?

Everyone has a different plan and remember that I always believe you should follow your own plan. It can be different from mine, but whatever it is, stick to it!

I would not blame you for cutting this trade loose because of the losses. But for me, at the time I still believed in the fundamentals for RIDE, no matter how wrong that might look now. 

We’re all wrong about these things, I’m not ashamed of it! I thought they could build a great fleet of trucks and sell them and be successful. But the stock price was just not reflecting this. 

So this is a great discussion point. This is where a short-term investment turned into a long-term one and as many of you know, I’ve been in this trade for a while now. 

What Should I Do With RIDE Now?

There are two possibilities for this RIDE trade: I could just liquidate it and take a massive loss. Before we do that, let’s take a closer look at the numbers.

RIDE

So looking at RIDE here, you can see I’m down a staggering $119,300 on the trade. Not great! I’ve been able to collect $17,184 in premiums but this still leaves me with a net loss of $102,116. 

In scenario one, if the stock drops 15-20%, no big deal! I could close my JWN position and still make a profit. 

For scenario two with LVS, when the stock dropped by 30-40%, I would have closed out at a loss of about $22,000. So based on my initial investment about a 9% realized loss. 

But scenario three with RIDE when the stock fell 80%, if I were to sell that right now I’d have a loss of $102,116, or about 41% of my original investment of $250,000. 

Yeah, that’s a pretty big ouch which is why I’m not planning to sell!

Where Does This Leave Us?

First of all, we’ve now learned the risks involved with trading The Wheel Strategy. The stock can go down, and nobody knows better than me that it can keep going down. 

When the stock goes down 15-20%, no big deal.

If the stock falls by 30-40%, not great but still not a major catastrophe. 

But the ouch really happens when the stock falls by 80% or more. 

There are certainly some lessons to be learned from the RIDE trade.

Stock Selection Is Key

So the question everyone is going to ask is: How can you avoid this? In the past, I’ve covered how important stock selection is when you’re trading The Wheel Strategy. For me, when I am choosing my stocks I go for value stocks. 

Stock Selection

Let’s bring up JWN in Google Finance and take a look at its fundamentals.

I like to look at things like annual revenues for the company. Obviously, 2020 was an outlier for most companies and Nordstrom was no exception. 

If we look before 2020, the revenues were growing as were the profits. Nothing crazy, but steady business growth is a telltale sign of a value stock. Both the top line and bottom line were growing steadily together. What else can you ask for?

LVS annual data

What about LVS? Annual data shows that the financial performance was improving from 2016-2019, and the profits were as well. Overall, the company looks good and again, another sign of a value stock. 

Now let’s take a look at RIDE. This is where you see where I made the mistake and violated my rule. What do you think happened here?

RIDE

Lordstown is as speculative as a company can get. It is a pre-revenue company because it has no annual revenues yes because it has no products delivered! They hadn’t produced one truck at the time that I entered the trade, and as of the time of this writing, it still hasn’t.

So what do we have here? A company with no revenues, no profits, massive losses, and no products. If I were sticking to my rules, I should never have bought this company or traded it. I’m showing you that you can learn from my mistake, so make sure you stick to value stocks. 

Using The PowerX Optimizer To Find Great Value Stocks

So here’s the cool thing about our PowerX Optimizer software: We can easily find great value stocks to trade. 

In the PowerX Optimizer, if we look at the stocks that are popping up on the scanner, we see stocks like Match Group (MTCH) like in the image below. 

We built this feature here so that you don’t have to just blindly say, “Oh okay, this is a good put to sell, so let’s just sell it.” No, no, no.

PowerX Optimizer

There are two things that I look for right off the bat when finding a good value stock.

The first is that it has to have a solid support level to sell puts at. And the second is also crucial: do you want to own this stock? 

PowerX Optimizer

We built in this little megaphone button here on the right and side of the page. When you click on it, it brings you to the Google Finance page for that particular stock. 

Let’s take a look at MTCH.

MTCH

Match Group looks like a company that is right between being a value and a growth stock. 

The company is growing, but not crazy growth. Annual revenues grow from $1 billion to $2 billion in about four years. It’s impressive but it’s steady, which makes me lean towards it being more of a value stock. 

So back to our criteria: do I want to own this stock? Sure! But do I want to own it at this current price of $152.50? Nope, not really. 

The next stock that pops up on the scanner is a company called Tapestry Inc. Here’s a quick view of its page.

Annual revenues for the company are pretty good but were down in 2020 when they reported a loss. This is understandable considering what happened that year. 

In 2021, the company got back on track though so 2020 was just the outlier. Do I want to own this company? Sure, it looks like a steadily growing company. Do I want to own the stock at $37?

Sure, it’s kind of been in a recent downtrend so it could break back upwards or it could continue down. Either way, it’s a decent price for this stock. 

See how I look for value stocks? RIDE was a mistake because I violated my own rules. Using the PowerX Optimizer can help you choose the right value stocks without being distracted by speculative companies. 

Summary

Okay, are you still with me? Let’s do a quick recap of this article and what we learned:

  • The Wheel Strategy is a wonderful trading strategy, but as we saw, there are certainly some risks.
  • What happens when a stock falls by 15%? 30%? 80%? We learned about all of these scenarios and how to calculate the realized loss you would incur. 
  • Stock selection is key, and we learned that firsthand with the RIDE trade. 

If a stock falls and you look at the company now and your investment thesis has changed you might say, ‘No, I don’t believe in it anymore’. That’s fine! Now you can consider getting out of that trade because you don’t want to own the stock anymore.

Remember, the downside potential for any stock is zero. The upside potential is nearly limitless depending on the company. It’s why I kept holding RIDE even though it was down by 80%. 

I hope this helped you understand the risks of The Wheel Strategy. It’s a great trading strategy that works a majority of the time, but sometimes, due to circumstances beyond our control, the trade gets away from us. 

Whenever you are trading there is always risk. You cannot eliminate the risk but you can minimize it and be prepared for it. 

The Wheel Strategy does take a certain amount of risk tolerance. If yours is lower, then perhaps something like credit spreads or debit spreads might better suit you. 

I hope you found this helpful because it’s something even experienced traders like me have to review once in a while. If you want to know how Mark and I personally trade these crazy markets, here are 2 videos I recommend you watch:

This one explains the PowerX Strategy.

This other one explains The Wheel Strategy in detail. 

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