James Cordier’s hedge fund lost $150m from selling options. His investors received an email stating they had lost all their money and owed more to cover a margin call.
He then recorded a cringe-worthy apology video where he apologized for ten minutes about how bad he felt.
You must learn about the OptionSellers blow up and James Cordier’s mistakes if you trade options to avoid making the same mistakes.
Who is James Cordier?
James Cordier is an ex hedge fund manager who managed around 290 people’s money.
However, his knowledge of options trading didn’t stop him from blowing up his hedge fund.
James Cordier’s net worth was significant until he took too much risk trading options.
Why Did OptionSellers Blow Up?
James Cordier piled the OptionSellers fund into a short call position on natural gas futures and a short put position on crude oil.
He was overleveraging into these positions and taking on a ton of risk.
Additionally, he was not hedging the portfolio with any shares or long calls, meaning the position on natural gas came with unlimited risk potential to the upside.
The image above shows the weekly chart of crude oil. James Cordier sold puts on oil, and you can see the series of red candles that wrecked his overleveraged position.
Therefore, James Cordier lost money on natural gas and crude oil, betting the exact opposite of what happened.
Understanding how to read stock charts is crucial if you want to become a successful trader. If you don’t have a charting tool, you can sign up for a TradingView free trial and get access to advanced charting tools to improve your analysis.
When you use my affiliate link to sign up for TradingView, you can get a referral credit and a 30-day free trial of the premium features!
The biggest mistake any option seller can make is trading too large for your account.
When you sell option premium, you can use a lot of margin since brokers don’t require you to put up a lot of capital to sell options.
James Cordier sold way too many call options than his fund could handle, and when the price of natural gas futures increased massively, he was margin called and lost all of the fund’s money and some.
He also sold many put options on crude oil that went against him and forced him to close the trades out with a negative account balance.
Lessons Learned: Trade Small
The biggest lesson learned from James Cordier is not to overleverage your account. You must understand how notional value works and keep it in check when you sell options. For example, selling a $100 strike put is $10,000 of notional value since it simulates 100 shares.
If you have a $25,000 account and are controlling $100,000 worth of notional value by selling options, you risk blowing up your account. The best way to manage your risk is to keep notional value at a reasonable level and buy options to hedge your short options. For example, if you sell a $100 strike put, consider buying a $90 strike put to limit your risk.
You should also backtest your options strategies to determine the maximum loss potential before using it to trade with real money. You can read my article about the best options backtesting software to see the top backtesting tools, but I highly recommend Option Omega. It allows you to perform 10+ year backtests with 1-minute historical data in minutes, making the process quite efficient.
James Cordier Apology Video
James Cordier of OptionSellers sent his investors an apology video that also went viral online.
Few people feel bad for Cordier since the losses would have been easily avoidable if he didn’t take on so much unnecessary risk.
James Cordier’s net worth was very high until he got margin-called and blew up his hedge fund.
OptionSellers Blow Up | Bottom Line
While you can make a lot of money using margin to trade options, it is a double-edged sword. You can blow up if the market goes against you and your portfolio is not hedged or sized correctly.
Understanding your risk tolerance is crucial to becoming a successful options trader. Regardless, you are bound to blow up if you trade too large for your account.
Therefore, you should always trade small and avoid getting cocky and piling too much risk into a single trade.
Before you go
If you want to keep educating yourself about personal finance, you must check out these posts as well:
SPX and SPY both track the S&P 500 index, but these two financial products have significant differences.
The products have different options settlement, contract sizes, and tax treatments.
If you are interested in trading the S&P 500, you must understand the differences between the SPX vs. SPY.
First, What is an Index
A stock index is a basket of stocks that may track the whole stock market or a specific market segment.
For example, the S&P 500 stock index seeks to track the top 500 large companies on the U.S. stock market.
The SPX ticker represents the S&P 500 free-float capitalization-weighted index. A cap-weighted index means the companies with the largest market caps are weighted the highest in the index.
Therefore, companies with the highest market cap will affect the index’s value the most.
What is an Index ETF
An index ETF (exchange-traded fund) is a fund that seeks to track the performance of a stock index, such as the S&P 500.
The SPY ETF is an S&P 500 ETF.
You can purchase shares of SPY to invest in the S&P 500 index, but you cannot buy shares of the SPX index itself. However, you can trade options on the SPX index to bet on its future prices.
What Are Options?
Options contracts are derivatives you can buy and sell to bet on an underlying stock or index price change.
There are two types of options: call options and put options.
Each option represents 100 shares of an underlying stock.
Trading Options on SPX vs. SPY
There are a few notable differences between SPX and SPY options:
SPX is 10x the size of SPY.
One SPX contract is worth the value of ten SPY contracts.
SPY options are American style.
SPX options are European style.
SPX options provide beneficial tax treatment since they are 1256 contracts.
60% of profits earned on SPX are taxed at the long-term capital gains rate.
SPY options pay you out in shares, while SPX is cash settled.
SPY pays a dividend which affects the price of call options.
Since a call option gives the buyer the ability to purchase 100 shares of stock, the dividend payment must be factored into the price of the call.
SPX vs. SPY Value
SPX is 10x the value of SPY. So, for example, if the SPX index is at 3,000, the price of one share of SPY is around $300.
Therefore, one SPY contract at this price is worth $30,000 of notional value, while one contract of SPX is worth $300,000.
Since there is usually a commission to trade options, you may be 10x the commissions trading SPY instead of SPX.
However, SPY is better for small accounts since it is 1/10th the size.
SPY vs. SPX Settlement Differences
SPX options are European style, while SPY options are American style.
European style options
They can only be exercised at expiration.
They are cash-settled.
Cash-settled options pay options traders in cash rather than shares of stock. For example, if you buy an SPX 3000 call option, and the index expires at 3,100, you are paid $10,000 cash rather than 100 shares at 3,000.
American Style Options
They can be exercised anytime on or before expiration.
They pay in shares of stock rather than cash.
Does SPY Pay a Dividend
The SPY ETF does pay a dividend to shareholders.
The image below shows that the dividend yield spikes when large market crashes happen, such as Black Tuesday and Black Monday.
The dividend yield spikes at these points because it is negatively correlated with the share price.
When the share price of a company falls, the dividend yield naturally increases.
If you are learning about selling options and are unsure whether the iron condor or iron butterfly is best, you have come to the right place.
Both of these strategies are similar, but there are some differences you must understand before deciding which one you should employ.
What Are Iron Condors and Iron Butterflies?
Iron condors and iron butterflies are delta-neutral options trading strategies. Both are option selling strategies as well, meaning you are short volatility. The jade lizard strategy is similar to an iron condor as well.
Since the strategies are delta-neutral, they will generate a profit when the underlying stock does not move in either direction. Additionally, if volatility drops after you sell an iron condor or iron butterfly, you will generate a profit due to the decrease in options pricing.
Iron Condor vs. Iron Butterfly
While both strategies have similarities, you must understand the differences to determine when it’s best to use each strategy.
What Is the Most Important Terminology Needed to Understand Iron Condor and Iron Butterflies?
One of the most crucial option terminologies you must know about these strategies is the difference between ATM (at the money) and OTM (out of the money) options. The ATM strike on an options chain is closest to the current share price.
In the images above, you can see that $BAC is trading at 33.15 per share. Therefore, the ATM strikes for both the put and call would be $33.
What Iron Butterflies and Iron Condors Have in Common
The main similarity that iron butterflies and iron condors have in common is they are both delta-neutral and short volatility. After selling an iron butterfly or iron condor, you want the stock price not to move at all, so theta decays at the options and generates a profit.
Additionally, both strategies generate a profit when volatility drops after you sell one. You can check a stock’s implied volatility rank (IVR) by adding the custom indicator to TradingView.
Another significant difference between the iron condor and iron butterfly is that they both have long options and are defined risk trades. Without the protection legs, an iron butterfly is a short straddle. An iron condor without long protection legs is called a short strangle.
The short straddle and short strangle are naked strategies, meaning they come with unlimited theoretical risk. However, since a stock can move up infinitely, call options do not have a cap on how high they can go.
Since calls have significant upside risk, some traders will employ a jade lizard strategy and sell a naked put with a call credit spread.
How an Iron Butterfly is Different From an Iron Condor
An iron butterfly differs from an iron condor since it has ATM short strikes. Since there is more extrinsic value present with ATM options, you will collect more premium than an iron condor.
Additionally, each trade’s profit zone differs quite a bit. For example, the iron butterfly has a narrow range the stock can move within, while the iron condor has a larger one.
The iron condor is slightly more conservative since you are selling strikes that are further away from the strike price.
Iron Condor vs Iron Butterfly: What Strategy is Better?
Like everything in the stock market, it is hard to decipher which strategy is better than another. So instead, it is essential to know when using one over the other is better.
Traders use various tactics to determine when it is best to use one strategy over the other, including technical analysis. Therefore, the strategy you choose should depend on your trading style and analysis of the underlying stock.
Some traders may prefer the larger profit zone of an iron condor, while others may enjoy the higher premium collected with an iron butterfly.
Example of an Iron Condor vs. an Iron Butterfly
One of the main differences between the iron condor and iron butterfly is how wide the profit zone is. For example, in the image below, you can see an iron butterfly on $BAC. The green area is the profit zone, so if the stock stays in this area each day, you will make money.
However, if the stock moves quickly in one direction, then the iron butterfly will show a loss. As a result, most traders who use the iron butterfly will take profit early, usually at 25% of the premium collected.
Taking profit before expiration is beneficial because you will increase your win rate by taking it off early. Taking profit early does leave 75% of the premium on the table. However, your profit may disappear if you hold past 25% profit, depending on how the stock moves.
Image of an iron condor’s risk diagram on tastytrade
When to Use an Iron Butterfly vs. an Iron Condor
The iron butterfly is better to use when implied volatility seems insanely high. Since the profit zone is smaller than an iron condor, implied volatility must work for you. However, if the stock starts moving too far in either direction and volatility stays elevated, you don’t have much of a buffer like an iron condor.
An iron condor is best used when implied volatility is elevated, but you think the stock will move in a larger range. Since you are selling OTM strikes with iron condors, the stock can move in either direction a bit further, making it a slightly more conservative strategy.
Before you learn how options work, you must know all the basic options trading terminology. If you don’t understand the terminology, you will struggle to grasp how to make income trading options.
Strike price (exercise price)
The strike price of an option is the price at which both parties agree to buy or sell the underlying stock.
Premium
The premium of an options contract is the price you can buy or sell the contract.
ITM (in the money)
An ITM option refers to a contract that contains intrinsic value. In other words, it is favorable for the buyer to exercise.
OTM (out of the money)
An option contract is OTM when it does not have any intrinsic value and is unfavorable for the contract owner to exercise.
Expiration date
The expiration date of an option is the last date on which the buyer can exercise the right to buy or sell the underlying stock.
Buy to open vs. buy to close
When you buy to open an option, you are opening a long position on the contract. Buying to close an option means closing a position you initially shorted by selling it to open.
What is a Call Option?
A call option gives the buyer the right, but not the obligation, to buy 100 shares of the underlying stock at the strike price.
What is a Put Option?
A put option gives the buyer the right, but not the obligation, to sell 100 shares of the underlying stock at the strike price.
Selling vs. Buying Options
Options traders can choose to buy or sell options contracts. The buyer of an options contract pays a premium for the right to buy or sell shares of the underlying stock. Option buyers are usually speculating on the direction a stock will move.
The seller of an options contract receives a premium in exchange for taking on the obligation to buy or sell shares of the underlying stock. Option sellers generally seek to generate income for their portfolio by collecting premiums from the option buyers.
The Best Options Income Trading Strategies
Now that you understand the basics of options, we will introduce some of the various options trading strategies you can employ.
Cash Secured Puts
A cash-secured put is when you promise to buy 100 shares of stock by selling to open a put contract. You will get paid a premium in exchange for taking on the obligation to purchase 100 shares.
Covered Calls
The covered call options strategy is when you purchase 100 shares of a stock and then sell a call option against them. Essentially, you are getting paid for promising to sell your shares at the strike price.
Credit Spreads
A call credit spread is when you sell a call option, then delta hedge it by purchasing a higher strike call option within the same expiration date. Call credit spreads are also known as bear call spreads.
A put credit spread is when you sell a put option, then delta hedge it by purchasing a lower strike put option within the same expiration date. Put credit spreads are also known as bull put spreads.
The iron condor options strategy is when you combine a put credit spread and a call credit spread. Therefore, it is a delta-neutral options strategy where you want the underlying stock price to stay in between the two credit spreads.
Short Strangle
The short strangle options strategy is when you sell a call and a put within the same expiration date. The short strangle is an iron condor without the long options to delta hedge, meaning the short strangle is a naked strategy.
Short Straddle
The short straddle is when you sell a call and a put option with the same strike price. It is the same as a short strangle, except the strikes must be the same and usually placed at the current stock price.
The jade lizard options strategy is when you sell a naked put option and a bear call spread within the same expiration date. The jade lizard is a short strangle, except the call side is a call credit spread, not a naked call. Tastytrade commonly uses this strategy to prevent upside risk.
Poor Man’s Covered Call
The poor man’s covered call is an options strategy that involves purchasing a deep ITM call option and then selling a shorter-term call against that call.
The Wheel Strategy
The wheel strategy starts by selling cash-secured puts until you are assigned 100 shares of stock. Once you own 100 shares, you sell covered calls until you get called away, completing the wheel strategy.
Short Put
A short put is the same as a cash-secured put, except you don’t set aside money to buy 100 shares at the strike price. Instead, you utilize margin to collect premium selling puts.
Rolling Options
Rolling an option is when you close your current position and simultaneously open a new one. Options traders roll their positions when they want to manage risk, extend their expiration date, or collect more premiums.
Rolling options forward means moving the position to a further expiration date. Rolling an option up or down means you are changing the strike price. You can also roll an option forward and up or down.
Implied Volatility Rank
The implied volatility of a security is a metric that determines how much the market believes the security will move. In other words, high implied volatility (IV) means that the market believes the security will move significantly. For example, the IV of a stock will rise around events such as earnings since investors believe the results will dramatically affect the stock price.
The IV rank of a security is a measure of the current implied volatility compared to the last 52 weeks. IV is based on a scale of 0-100, where 0 is the lowest IV print, and 100 is the highest IV print over the last 52 weeks.
The stock’s IV percentile is another metric that compares a security’s current IV with its last 52 weeks of trading. The difference is that the IV percentile states the percentage of days over the previous 52 weeks that IV traded below its current implied volatility.
Options Greek Cheat Sheet
The options greeks are crucial to know for options traders because they give you insight into how an option contract will react to changes in volatility, stock price, time, and more.
Delta
An options delta has two meanings. The first meaning of an options delta is the probability that it will expire ITM. The other meaning of delta is the amount an option will change for every $1 increase in the underlying stock price.
Theta
The theta of an option is the amount an option will decrease for every day that passes.
Vega
The vega of an option is the amount an option will change for every one-point change in implied volatility.
Gamma
Option gamma is the second order greek to the delta. It measures the rate of delta change for every one point move in the underlying stock.
Vomma
Vomma is the second-order greek to vega. It measures the amount vega will change based on implied volatility changes.
Color
Color is a third-order greek that measures the rate at which gamma will change over time.
Charm
Charm is a second-order greek that measures the amount an options delta will decay over time.
Rho
Rho is the amount an option will change based on a one-point move in interest rates.
Evaluating Your Risk Tolerance
Before you start trading options, you must determine your risk tolerance. Then, depending on your trading experience, you may want to start with smaller trades so you do not get emotional after placing a trade.
If you are brand new to options trading, you should start small until you experience a bad trade. It is impossible to replicate how it feels to lose your hard-earned money without actually losing it on an options trade.
Risk/Reward of Options Strategies
There are many different options strategies, and they all come with different risk profiles.
Buying a call
Buying a call option is an easy trade to understand because the max risk is the price you pay for the contract. However, you must realize that call options expire, and if the stock doesn’t move above your strike price before it expires, you will lose all your money.
The most popular call buying strategy is buying LEAPs (long-term anticipation security). A LEAPs call is a call option with over a year until expiration. LEAPs are an excellent call buying strategy because you have a long time until expiration, and it is similar to holding stock shares for much cheaper.
Buying a put
The maximum loss when buying a put is the price you pay for the contract, just like buying a call. Traders may buy puts to hedge their long stock portfolios, speculate on the stock market’s decline, or want to go long volatility.
Buying a put is an excellent way to short a stock without using margin. However, you must deal with picking the correct expiration date.
Writing a put
The maximum risk you face when writing a put option is being assigned 100 shares of the underlying stock at the puts strike price. Many traders, even Warren Buffett, sell put options to generate income and purchase a stock since the reward is collecting the option premium.
If you have a margin account, you may be able to sell a lot more put options than your account can handle. Therefore, you must understand the risks you are taking, and if you are unsure, only trade cash-secured puts.
Writing a call
Writing a call is the riskiest options strategy because your max risk is theoretically unlimited. For example, the max risk of selling a naked call option is you end up short 100 shares of the stock at the strike price.
Stock prices can continue up indefinitely. Therefore, short sellers have unlimited risk. However, if you own 100 shares of stock and sell a call, that is a much safer strategy called the covered call.
Reasons to Trade Options
The primary use of options trading is to hedge risk. For example, investors can buy put options to limit the downside risk on their stocks.
Traders can also buy call options to hedge a short position. Since short positions have unlimited risk, you can cap the exposure with call options.
How do Call Options Make Money?
Call options make money when you buy them, and the stock moves up shortly after. However, there are other factors working against you, such as theta or time decay.
For example, if you buy an OTM call option and the stock stays flat for the next three months, you will lose money because expiration is getting closer.
The safest way to buy call options is to purchase long-term ITM call options. This strategy is the safest because ITM call options have intrinsic value and are less affected by theta decay.
Selecting the Right Options to Trade
Selecting the best options to trade is based on a few factors. Most importantly, you must know if you are bearish or bullish on the underlying stock.
You can buy a call option or write a put if you are bullish.
If you are bearish on a stock, you can buy a put or write a call.
The next question is whether selling or buying an option is better. If implied volatility is high, it is generally better to sell options and vice versa.
For example, if you believe a stock is overvalued and the implied volatility is elevated, it would be better to sell a call than buy a put.
Can I Sell Options Immediately?
Yes, you can sell your option anytime you want after buying it. Depending on the goals of the trade, you can hold it until expiration or sell it early.
However, the stock market must be open for you to buy and sell options. When it is closed, you are not able to trade actively.
Options Trading Tips
Deciding which options to trade can be confusing if you don’t have a strategy outlined. To increase your trading confidence, you should primarily determine whether you want to sell or buy options.
Option sellers have a high win rate but then have big losers.
Options buyers lose a lot but occasionally have a big winner.
You can see significant losses if you do not manage your risk as an option seller. Many traders that sell options spend some of the collected premium on purchasing options to hedge their short options trades, forming a spread.
Regardless of your chosen strategy, your main goal is to manage risk. Options trading is risky, and you can blow up your account if you do not understand your risk tolerance.
The Ultimate Guide to Generating Income With Options
Regardless of your position in the stock market, you can utilize various options strategies to generate income or hedge your portfolio. Even investors like Warren Buffet use options strategies like the cash-secured put to purchase shares of stock at a discount.
However, options trading is not suitable for everybody with the risks involved. Therefore, before starting options trading, you must figure out how to create a profitable trading system. If you blindly go into the options market, you have a low chance of being profitable.
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The poor man’s covered call strategy (PMCC) is a fantastic method if you want to trade options for income with minimal capital requirements. The PMCC strategy is a bullish trade; therefore, you should use this strategy when you believe an underlying stock will increase in price.
Selling Covered Calls
The traditional covered call strategy involves owning 100 shares of stock and then selling a call option against them to collect a premium. You simply promise to sell your shares to the call buyer for a cash premium.
However, 100 shares of some stocks are a big chunk of change. Therefore, the poor man’s covered call is an excellent alternative if you want to trade a similar strategy with much less money.
How to Enter a Poor Man’s Covered Call (PMCC)
You can construct the PMCC strategy by purchasing a deep ITM (in the money) call and selling a shorter dated OTM (out of the money) call against it.
Many traders buy the long call with 300+ days until expiration (DTE) with a delta of 70 or higher. The delta determines how many shares the call option currently simulates, meaning a 70 delta call option is like owning 70 shares.
The short call can be within any expiration date shorter than the long one. However, option selling educators like Tastytrade prefer to sell options with an expiration of around 45 days until expiration (DTE). Tastytrade conducts various backtests and concludes that 45 DTE is the optimal timeframe to sell options.
How to Calculate Max Profit / Breakeven
The most important part of setting up a poor man’s covered call is ensuring you do not have any upside risk. If the call option you sell is not high enough, it may limit your profit when the stock moves up.
The rule you must follow is to make sure the width of your two strike prices is larger than the debit you pay. Let’s take a look at an example in the image below.
PMCC strategy in a Thinkorswim risk diagram
In the image above, we have created an order to purchase the 280 strike SPY call and sell the 400 strike call with a shorter expiration. The difference between these strikes is 120.
The debit we must pay for this PMCC is 114.53, meaning there is no upside risk. You can also tell on the risk diagram that if the stock continues up, there is no chance of losing money. The breakeven is shown on the chart as well at 370.91.
However, it is impossible to compute an exact breakeven price of this strategy since many factors will change daily.
Poor Man’s Covered Call Example
To clarify the PMCC strategy, let’s look at a hypothetical example. We will pretend that stock XYZ is trading at $100 per share, and you believe it will increase to $115 per share in the next two months.
PMCC example:
Buy +1 $90 strike call option for $20.00 ($2,000) at 500 DTE
Sell -1 $120 strike call option for $0.50 ($50) at 45 DTE
If you are correct in your assumption, and stock XYZ rises to $115 in 45 days, you will make money on both call options.
The $90 strike call option you purchased will go from about $20.00 to about $35.00, while the $120 call option you sold will expire worthless, allowing you to keep the $50 premium as income.
PMCC in ThinkorSwim Analyze Tab
Poor Man’s Covered Call Risks
The PMCC strategy is a fantastic strategy when you are right. However, if you are wrong, you must understand the risks involved. A few scenarios can happen that will make you lose money with a PMCC strategy.
1- Stock XYZ falls to $50 per share
If stock XYZ falls after you enter a PMCC, you will lose money on the $90 strike long call option. Since the stock is below the strike price, there is no more intrinsic value, meaning the option can go to $0 if you hold it until expiration. You will still make the $50 from the call you sold, but this only covers a fraction of the losses incurred from the $90 strike call option.
2- Stock XYZ goes sideways
If stock XYZ doesn’t move, you will watch your long call option slowly bleed due to time decay (theta). You will make a little bit of money from the $120 call option that you sold, but you will likely lose more on the $90 call option.
Poor Man’s Covered Call vs. Covered Call
A regular covered call involves purchasing 100 shares of stock and selling a call against them. In comparison, a PMCC is when you buy a call option instead of 100 shares and sell a call option against the long call option.
The benefit of using the PMCC over the traditional covered call is that you need much less capital. If you are using a smaller trading account, you may not be able to afford 100 shares, making the PMCC a better method.
However, the benefit of the traditional covered call strategy is that equity does not come with an expiration date. You can hold shares of stock forever with no worries, but call options will eventually expire.
Therefore, if the stock does not increase before expiration, you may lose all of your investment with a PMCC strategy. You can buy to close the short call before expiration to lock in profits, but there is never a guarantee to make a profit.
Another strategy to consider other than the poor man’s covered call is the wheel strategy, cash-secured puts, and covered calls. These three strategies are safer because you hold shares rather than a long call option.
Call options can expire worthless, but you can hold a stock forever. If the trade goes sideways, you will be much better off if you are trading a covered call rather than a poor man’s covered call.
PMCC Strategy: Bottom Line
The PMCC strategy can make you a lot of money if the underlying stock moves up for you. Additionally, you can use the strategy with small accounts since you don’t need to purchase 100 shares of stock like a traditional covered call strategy.
Overall, the traditional covered call strategy is safer since you can hold the shares forever without worrying about them expiring. The conventional covered call is safer but requires more capital which is the tradeoff.
The PMCC options strategy is beneficial because you can utilize it with little capital and take advantage of leverage. For example, if you use margin to buy stocks, you will pay margin interest, while options give you leverage for free in exchange for an expiration date.
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The wheel strategy, also known as the triple income strategy, is a consistent way to generate income on the stock market. The wheel combines trading options with stocks to outperform the classic buy-and-hold investing strategy.
What is the Wheel Strategy
The wheel options strategy is a method that combines the cash-secured put and the covered call. The wheel strategy is a bullish trade, meaning it will make money if the stock you pick moves up.
Cash Secured Puts
A cash-secured put is an options trading strategy that allows you to purchase shares of stock at a discount. When you sell a put option, you promise to buy 100 shares at the strike price of the put option you sold. In exchange for taking on the obligation to purchase shares, you receive a cash premium, similar to a dividend.
Covered Calls
A covered call is an options trading strategy that allows you to get paid a premium for promising to sell your shares of stock. Instead of selling your shares on the open market, you can sell a covered call and receive an extra premium for selling your shares.
Covered calls are also a fantastic hedge for your investment portfolio since they provide income when stocks decrease in price or stay flat. In addition, you can collect cash payments from option premiums and dividends if you sell a covered call on a stock that pays a dividend.
The Wheel Strategy Explained
The triple income strategy is composed of just three simple steps to follow. Regardless of your skill level, the wheel strategy is not complex and is a great way to generate income on the stock market.
1- Sell cash secured puts until you are assigned.
To start the wheel options strategy, you must pick a stock you wouldn’t mind owning and sell a cash secured put on it.
Cash Secured Put Risk Diagram
Then, continue selling puts until you get assigned stock. If the option expires before you get assigned, simply sell another one.
2- Sell covered calls until you are assigned.
Once you have 100 or more shares of the stock, you will sell covered calls on them until you get assigned again. When you get assigned on a covered call, the shares will automatically get removed from your account, and you will keep the premium as income.
Covered Call Risk Diagram
3- Restart the wheel strategy by selling another cash secured put.
Now that you have completed the wheel and have no shares in your account, you can repeat the same steps. The goal of the wheel strategy is to generate income from the options you are selling. Any capital gains you make from the stock are just a bonus.
Cash Secured Puts and Covered Calls are the Same Thing
As you can see in the risk diagrams above, there is no difference between a covered call and a cash secured put.
Buying 100 shares and selling a $50 strike call is the same as simply selling a $50 strike put. However, the wheel strategy is great because it is a systematic way to combine these two effective strategies.
Wheel Strategy Example
Let’s say stock XYZ is trading at $100 per share. You are bullish on the stock and wouldn’t mind owning it at this price, so you decide to start the wheel by selling a put.
Sell -1 $90 strike put for $100 in premium
After you sold the $90 strike put, the stock tanked to $80, so you got assigned and received your $100 premium. Therefore, you currently own the shares at $89 per share, including the premium.
Sell -1 $100 strike call option for $100 in premium
The next move you make is selling a covered call with a strike price above your $89 cost basis at the $100 strike. If you pick a strike price for the covered call below your cost basis, you could be forced to sell at a loss.
After you sell the $100 strike call, the stock rises to $110 per share, and you are called away. The shares automatically get sold at the strike price of $100, and you keep the $100 premium.
Therefore, this trade generated a profit of $1,200. In addition, you made $1,000 from buying the shares at $90 and selling them at $100. Additionally, you collected a total of $200 premium.
4 Things to Know About the Wheel Strategy
Only trade stocks you are willing to hold forever.
If you pick a stock only because it has high option premiums, you may feel inclined to sell at a loss if the stock price declines. If you do not want to pick individual stocks, you can utilize the wheel strategy on ETFs like SPY.
Keep track of your cost basis.
When you are selling options, you will collect a lot of option premiums. Therefore, you should keep track of all the premiums you collect and subtract them from your cost basis when you are assigned shares.
For example, if you sell a $100 strike put for $0.50 ($50) in premium and get assigned, you will own 100 shares at $99.50 per share instead of $100 per share. You must add the premiums you collect and subtract them from the price you own the shares to determine your actual cost basis. In this case, you would do $100 – $0.50 to get your cost basis of $99.50.
Only sell covered calls at or above your cost basis.
If you own shares of a stock at $99.50 and sell a $90 strike call option, you risk selling the stock at a loss. However, if the stock is trading at a much lower price than your cost basis, it may be best to hold it until it goes higher.
Worst case, you can bite the bullet and accept that you may need to take a loss. However, if you are okay with holding the stock forever, you can be patient and wait for it to recover.
Trade with a reliable broker
Commission free brokerages like Robinhood may be appealing due to the low fees, but they are not a good choice for options trading. Brokers like tastytrade and thinkorsiwm will give you better fill prices and do not exercise options early like Robinhood.
Ultimately, the choice is up to you, but tastytrade has a great desktop platform and mobile app. Additionally, the requirements to get a margin account on tastytrade are much lower, making it much more option-friendly.
If you are an options trader, signing up for tastytrade is probably the best bet overall, as it is much newer than thinkorswim.
The Best Stocks for the Wheel Strategy
To start trading the wheel options strategy, you must find stocks you can afford to trade. Since options require you to trade 100 shares at a time, you will be limited if you have a smaller trading account.
For example, if you have a $5,000 trading account, you can only sell puts on stocks and ETFs that are $50 per share or less. You can get around this if you have a margin account, but as a beginner, it is best to stay away from leverage until you have more experience.
Best Stocks to Wheel Under $50
A reminder that this is not financial advice, and I am only providing these stocks to show you an example of companies that trade for less than $50 per share.
Bank of America ($BAC)
Intel ($INTC)
Financial Sector ETF ($XLF)
Coca-Cola ($KO)
Kroger ($KR)
Walgreens ($WBA)
Ford ($F)
Bottom Line: The Wheel Strategy
While the wheel strategy looks impressive in theory, there are always pros and cons to any system on the stock market. One of the downsides of the wheel strategy is when the stock you are trading increases in value rapidly.
You will still make money when the stock moves up, but you would make more if you simply owned 100 shares of stock. Additionally, if you get assigned on a stock, and it drops hard, you may not be able to sell covered calls above your cost basis.
You must understand implied volatility when trading options because it will determine how expensive options are trading for.
Before you go
If you want to keep educating yourself about personal finance, you must check out these posts as well:
Selling covered calls is a fantastic way to protect your stock investments.
What is a call option?
A call option is a contract that gives the buyer the right to purchase 100 shares of stock at the strike price. For example, if you buy a call option for stock XYZ with a strike price of $100, you will have the right to purchase 100 shares of stock at $100/ share.
Buying a call will profit when the stock price increases.
The call option buyer must pay a premium to purchase the contract. This premium is constantly changing depending on the stock price and implied volatility.
Traders can also write or sell call options. Selling a call is the opposite of purchasing one, so you will collect the premium for accepting the obligation to sell 100 shares of stock at the strike price.
Selling a call will profit when the stock price decreases or doesn’t move.
What is a covered call?
The covered call strategy is when you own 100 shares of a stock and sell a call against those shares. You simply promise to sell your shares and collect the option premium as income. This strategy is a good hedge if you are bullish on the stock long-term but believe it will come down or not move in the short-term.
How does a covered call work?
When you sell a call option, you collect a cash premium in your account, just like a dividend. You can immediately use the premium to purchase more shares or even withdraw it to your bank account.
If the stock price exceeds your strike price, the call might automatically exercise and remove the shares from your account. However, even if they get assigned and the shares get removed from your account, you will still keep the premium as income.
Tips For Selling Covered Calls:
Pick a strike price you would be okay selling the stock at.
Sell covered calls after the stock price has increased to maximize the premium collected.
Don’t sell cheap contracts; the risk to reward isn’t worth it.
Take profit when you collect 50% or more of the premium on the call.
Covered call example
Let’s say that you buy 100 shares of the stock $SPY at $400 per share. If you believe that $SPY will consolidate in the near future, you can sell a covered call with a strike price of $450 to generate some income while holding your shares.
If the shares of $SPY go above your strike price to $480, you must still sell your shares at $450. However, you will still keep the premium if assigned and forced to sell your shares. If the shares are still at or below $450 at expiration, then you will keep your shares and pocket the premium as income.
The primary risk involved with this strategy is not the call option; it is the 100 shares of stock. However, a few scenarios can happen after selling a covered call.
1- The stock does not move
It is good when the stock doesn’t move because you make money on the call, and the shares don’t affect you.
2- The stock goes above the strike price
If the stock price exceeds the call’s strike price, you may be obligated to sell them at the strike price. For example, let’s say you bought stock XYZ at $90/ share and sold a covered call with a strike price of $100.
If stock XYZ goes to $110, you will still be obligated to sell the shares at $100. You will still collect the premium, but you will miss out on share price appreciation.
3- The stock decreases in price
When the stock declines in price, the shares lose money, and the call option makes money. The covered call will help hedge your portfolio, but you can incur significant losses if the stock falls hard.
If you own 100 shares of stock, this is 100 deltas of exposure. Many traders sell covered calls with a delta of 30, which will hedge 30 shares of your stock. The 100 shares of the stock are the most prominent risk because they have more delta than the covered call.
If the stock falls, the call’s delta will also drop. Therefore, you will be less hedged when the delta drops as the stock falls. If the call delta gets too low, consider taking profit and selling a new covered call.
The Best Delta for Covered Calls
Traders often use option delta to determine strike prices for covered calls. Ultimately, the best delta to sell depends on each situation.
For example, if you believe the stock has a lot of upside potential, you can sell a lower delta covered call around 10-15 to reduce the chance of your shares being called away.
On the other hand, if you believe the stock will not move much higher, you can sell a call with a delta of 30-50 to collect the most premium and protect against downside movements.
Best Stocks for Selling Covered Calls
Depending on your account size, the best stocks for selling covered calls will differ due to margin requirements. For example, if you have an account of $10,000, you will only be able to trade stocks worth $100 per share or less.
The best stocks for selling covered calls are those you do not mind owning forever. Unlike options, shares of stock don’t expire, so you can hold them all sell calls until your shares get called away.
However, if you pick a stock just because it has a low share price, you do not understand your investment and are more likely to sell it at a loss. You must analyze a stock with technical and fundamental analysis to determine if it’s a good investment.
Bottom Line: What is a covered call?
A covered call is a promise to sell your shares at a specific price, known as the strike price. Regardless of where the stock goes, you collect the option premium as income, making it a consistently profitable strategy.
The main risk is that you must sell your shares at a lower price. However, even in this case, you are still making money, just less profit than you could have made by not selling the covered call.
Therefore, when you sell a call option, you must pick a strike price you are okay with selling your shares. In the worst-case scenario, you miss out on some profit due to a sharp increase in the share price.
Selling covered calls is not about hitting home run trades; instead, it generates consistent income. Additionally, you can buy to close the covered call before it expires to secure profit.
This basic concept can improve your knowledge as an options trader.
What is the break even point of an option?
When you buy an options contract, you are purchasing the right to buy or sell 100 shares of stock at a specific strike price. As an options trader, you have the benefit of leverage.
When you purchase 100 shares of stock without an option, you know exactly what price you paid per share.
However, when you buy a call option to purchase 100 shares, you must account for the premium you paid when calculating your cost basis.
When you buy a call option and exercise it, the breakeven point will be your cost basis of the shares.
Image from Thinkorswim Trading Platform
Break even point formula
Call option break even formula:
Strike price + premium paid
For example, if you buy a $100 strike call option for $1.00 per share in premium, your cost basis if you exercise the option would be $101.
Therefore, if you decide to exercise this option, you would own 100 shares of the stock at $101 per share, including the premium for the option of $100.
Put option break even formula:
Strike price – premium paid
For example, if you buy a $100 strike put for $1.00 per share in premium, your cost basis would be $99.
When you buy a put option, you are betting on the stock moving down or hedging your portfolio.
Therefore, if you exercise a put option, you will be short 100 shares at your break even point of $99 per share in this example.
What if you don’t plan to exercise?
You are not obligated to exercise and take the shares when buying options. Instead of exercising, you can simply sell the contract to close it.
Options have the potential to make you a lot of money but buying them is a low-probability game. You will likely lose more than you win, but this is fine if you have a positive EV trading system.
If you want to become an options trader, you must understand call options!
What is a call?
Call options give the buyer the right to purchase 100 shares of stock at a specific price. The price that is agreed upon is known as the strike price. As an options trader, you can use calls to leverage your portfolio.
Unlike shares of stock, options contracts eventually expire on their expiration date. If the strike price of your call is below the price of the stock at expiration, the option will expire worthless. However, it is cheaper to purchase a call option than 100 shares of stock.
* Call options for dummies: example trade
Let’s say stock XYZ is trading at $100 per share, and you expect it to rise to $120 per share in the next month.
You can either buy 100 shares of stock at $100 per share or a $100 strike call option. 100 shares of stock would cost you $10,000 (100*100). A $100 strike call option will cost you about $500 with an expiration date of 3 months.
The price to purchase a call option is much cheaper than the price to purchase 100 shares of stock. In addition, it’s cheaper to buy the call because it has an expiration date and allows you to use leverage.
Scenario 1: The stock rises to $120 in one month
If you are right and the stock price increases to $120 in a month, you will be making good money. Let’s compare how the shares did when compared to the call option.
If the strike price of your call is $100, and the stock is currently trading at $120, the option has $20 of intrinsic value (120–100). Since options have a multiplier of 100, the value of the contract would be at least $2,000 (100*20).
The call option you purchased for $500 increased to a minimum of $2,000, providing a return of $1,500 or 300% [(2,000–500)/500=3].
If you purchased 100 shares for $10,000, you would be able to sell them for $12,000, providing you with a return of $2,000 or 20%.
Scenario 2: The stock falls to $80 in one month
If you are wrong, you will lose money on both the call option and the shares. The main difference is that you can continue holding the shares forever while the call option can expire worthless.
The $100 strike call you bought will lose much of its value since the stock moved from $100 to $80 per share. Determining option pricing is complex, but the call likely lost over 50% of its value and is trading around $1-$2 ($100-$200). In this case, you will probably lose about -$300 to -$400 or over 50% of your investment.
The shares you purchased for $10,000 are now worth $8,000, resulting in a loss of -$2,000 or -20%. Luckily, the shares do not expire, so you can hold them until they recover. However, the stock does not have to recover and can even go to $0.
Options trading for dummies
Options trading for dummies is possible as various strategies are easy to implement. If you sell options in a stock portfolio, you rarely have to check on them or manage the position.
Discover the difference between buying and selling call options below and why selling options for dummies is easily attainable. Buying options contracts can work, but it is riskier than an option selling strategy.
Buying calls vs. selling calls
Buying calls is a speculative strategy that is riskier than investing in stocks. As a call buyer, you are taking on more risk by using leverage to make a higher return. As the seller of the call, you are betting that the stock will move down or stay flat.
Covered calls for dummies
A covered call is when you own 100 shares of stock and sell a call against them. When you sell a call, you promise to sell your shares at the strike price in exchange for a cash premium.
Additionally, for accepting the obligation to sell your shares, you get paid the contract’s premium from the call buyer. You are betting that the call option you sold will go to $0 and expire worthless.
Covered call risk diagram on $SPY
Selling covered calls is a great way to hedge your portfolio and earn some income for holding your shares. The downside to selling calls is that you will be forced to sell your shares if the stock moves up quickly.
The key is to pick a strike price at which you are okay with selling your shares. If you choose a strike price that is too low, you can miss out on the gains from the stock increasing in price. As an options trader, you must determine if a stock will move up, down, or sideways.
Buying LEAPs
If you are bullish on a stock, you can purchase call options that expire in one year or longer. These options are known as LEAPs (long-term anticipation securities). The benefit of buying LEAPs over equity is they are cheaper and allow you to use leverage.
Buying a call option before a stock goes higher is one of the best ways to make a great return in a short period. However, buying call options is risky, and you can lose your entire investment if your investment thesis is wrong.
Options trading for dummies: bottom line
When you are trading call options, you must understand the risks involved. For example, when you buy a call option, you can lose your entire investment if the stock expires below your strike price. Therefore, you must be willing to lose all of your investment when purchasing speculative financial instruments like call options.
As the seller of call options, you can use the covered call strategy to generate income for a stock portfolio. Selling covered calls are much less risky than buying call options, but the risk potential is lower. Additionally, you must understand how implied volatility affects options pricing.
Regardless of how you trade call options, you must understand the risks involved and be ready to manage them. Options are much more complex than trading shares of a company, which means you must be careful and avoid them if you aren’t fully aware of all the potential outcomes.
I replicate a long SPY portfolio by selling put options on either /MES, SPY, or SPX. Depending on the week, I use a SPY puts strategy and will generally sell to open about 1–2 contracts which are dependent on my account size and risk tolerance at the time.
The idea is that I am trying to generate a higher sharpe ratio than the market utilizing an SPX trading strategy instead of just owning shares of an S&P 500 fund.
I do this by shorting puts and controlling my delta exposure by rolling the contracts when I feel it is a good time. Additionally, you can use the S&P 500 futures options to sell puts instead of SPX.
Additionally, I spend some of my premium from selling puts to purchasing long puts to hedge.
Image from thinkorswim
What do financial advisors recommend?
Many people will go to a financial advisor to manage their money because they do not want to deal with the stock market. Most advisors will put you in an index fund that will perform similar to the S&P 500. Depending on your age, they may also put some of your money in the bond market.
Many famous investors, such as Warren Buffet, also recommend that most people simply invest in the indexes and hold them long-term. If American companies continue to do well, this index has proven it will go up over time. However, deciding to trade stocks vs options is a decision depending on each person’s situation.
As you can see in the TradingView chart above, the market has had rough times but always recovers. The same thing cannot be said about all stocks, though. A great example is the company General Electric (GE), as you can see in the chart below. This company used to be one of the top S&P 500 companies, but now it has fallen and never recovered to its previous highs.
The point here is that those safe companies can quickly turn into losers depending on when you buy them. If you stick to trading the indexes like the S&P 500, all bad companies are automatically removed, so you don’t have to worry about stock picking.
There have been many backtests done on SPX trading strategies, but I believe the best resources have been provided by David Sun. You can view his website here, and I will link this 90 DTE SPX trading strategy backtest here.
This backtest sells 15 delta puts closest to 90 dte. The management uses a 60% take profit level and a -200% stop loss. I won’t go into all of the details, but it is clear that selling puts on the index can beat buy and hold.
Volatility risk premium (VRP)
The volatility risk premium is the idea that implied volatility tends to be higher than actual volatility. In layman’s terms, people generally overestimate how much the stock market will move in the short term. When this happens, put options become overpriced since people speculate that the market will fall harder than expected.
Implied volatility — the price of options.
Actual volatility — how much the market actually moves.
When implied volatility ends up being higher than how much the market moves, the option sellers win. Most of the time, this will be the case, but you must manage your risk when the market draws down more than expected.
My SPX trading strategy combines proven ways of making money
So far, we have learned that the safest ways to make money in the stock market are to buy and hold an index or sell option premium. You can sell options on single stocks, but this requires constant speculation, and you could be wrong.
A superior stock market strategy is formed by combining holding an index and selling options. Many traders attempt to beat the S&P 500 index using single stocks, but you can easily trade an options strategy on the index itself in an attempt to beat it.
Trading the indexes will also provide the most conviction. There is a much greater chance that an index will provide steady returns than any single company. You will never have to worry about bad news reports or industry analysis since the index will pick all the stocks for you. The indexes have always recovered previously, and if you are looking for consistency, an index will be the best option to trade.
Buy and hold wasn’t good enough for me
I wanted to find an excellent way to beat buy and hold while having more control of my portfolio. I developed a strategy with positive expectancy that is also correlated to a buy-and-hold approach.
Bottom line
Historically, the surest way to make money on the stock market is to buy and hold the S&P 500 and sell option premium. I combine these approaches by simulating a long S&P 500 stock portfolio by selling put options with an SPX trading strategy.
Selling premium has been backtested by many people, and due to the volatility risk premium, it has positive expectancy over time. Anybody can learn about options trading, especially with a guide like this post called puts and calls for dummies.
