Capital Allocation & Risk Management

1. Why capital allocation matters

The Wheel can generate option premium, but it also creates obligations and the possibility of owning shares. Every cash-secured put ties up capital, while an assigned position exposes you to movements in the underlying share price.

One thing I've learned is that finding a good-looking premium is only part of the decision. I also need to consider how much of my account that trade would commit and what happens if the share price falls.

Before opening a position, I want to understand:

• How much of my account is available for Wheel trades.
• How much I want to keep in reserve.
• How much capital I'm prepared to commit to one company.
• How many positions I can comfortably manage at once.
• What my overall exposure could look like if several puts were assigned.

2. How much capital should you deploy?

There isn't one allocation percentage that works for everyone. It depends on account size, financial circumstances, risk tolerance and how much flexibility you want to retain.

For a smaller account, my starting example is to make around 60% available for Wheel positions and leave the remaining 40% uncommitted.

Using a hypothetical $20,000 account:

As an account grows, I would consider adjusting that balance towards 50% available for trading and 50% held in reserve. The aim is to retain flexibility rather than automatically increase the amount of capital I put at risk.

3. Why I want cash in reserve

This is one of the most important parts of my approach. I don't see uncommitted cash as money sitting idle. I see it as capital that gives me more choices when the market isn't behaving as expected.

When several puts are assigned

Imagine I've sold puts on several companies and the market experiences a significant decline. A number of those puts could end up being assigned, leaving me holding shares that are now worth considerably less than the original strike prices.

At that point, I may be selling covered calls against those shares. But if the share prices have fallen significantly, the premiums available at strikes that make sense relative to my adjusted cost basis may be quite limited.

My capital could then be tied up in shares while I'm waiting for a better opportunity to manage those positions.

Keeping opportunities available

Having cash in reserve means I can still consider selling puts on other suitable companies without having to close existing holdings simply to free up capital.

Avoiding forced decisions

If every available dollar is committed, I have fewer choices when several positions move against me at the same time. I don't want to be forced into closing a position or taking a trade simply because I've used too much of my account elsewhere.

Keeping personal finances separate

Money needed for household expenses, emergency savings, debt repayments or other near-term commitments should not be treated as available options-trading capital.

It's also important not to double-count cash. Money already committed as collateral for an open put is not available to secure another position.

4. Position sizing: How much should I commit to one stock?

Even if I have a trading allocation of $12,000, I don't want one company to consume most of it. I prefer to set an individual stock limit based on the total account value.

For my smaller-account example, I use a maximum planned allocation of around 10% per company.

On a $20,000 account, that gives me a planned limit of $2,000 per stock.

As the account grows, I would consider reducing my individual company limit towards 5%. That helps prevent a larger account from becoming overly dependent on a small number of stocks.

How this applies to cash-secured puts

A standard US equity options contract usually represents 100 shares. Selling one cash-secured put with a $20 strike therefore requires $2,000 in collateral, before considering any broker-specific requirements.

If my planned maximum allocation to one company is $2,000, that single contract uses the entire allocation.

What happens after assignment?

If I'm assigned 100 shares at $20, I own shares purchased for $2,000. If the price subsequently falls to $15, the holding has a market value of $1,500.

That's a $500 reduction in market value, or a 25% fall in the share price, before accounting for premiums, fees and other costs.

This is why I want to be comfortable owning the company before selling the put. The possibility of assignment needs to be part of the original decision.

5. Diversification: Avoid putting everything into one sector

Holding several different stocks doesn't automatically mean a portfolio is diversified.

For example, selling puts on five technology companies gives me five separate positions, but those companies may still be affected by many of the same market conditions.

When looking at my overall exposure, I consider:

• Companies: Avoid becoming too dependent on one business.
• Sectors: Consider exposure across industries such as technology, healthcare, consumer goods and financials.
• Business models: Different types of companies can respond differently to economic conditions.
• Market sensitivity: Consider how positions might behave during a wider market sell-off.
• Expiration dates: Avoid unnecessarily concentrating all my decisions around one expiration date.

6. Worked example: Building a $20,000 Wheel account

Let's bring the allocation principles together using a hypothetical $20,000 account and the smaller-account framework I've described.

Step one: Set the trading allocation and reserve

Step two: Set an individual stock limit

Using a maximum planned allocation of 10% of the total account per company gives me $2,000 per stock.

Step three: Consider potential positions

These four illustrative cash-secured puts would commit $7,300 in collateral. That leaves $4,700 of the $12,000 trading allocation uncommitted, alongside the separate $8,000 reserve.

In this example, I'm using one standard contract per company, with no overlapping positions in the same underlying. I'm also assuming sufficient cash is available to secure each contract.

7. Understanding your true exposure

I think it's important to distinguish between the cash required to secure a put and the economic risk of owning the underlying shares.

Cash-secured puts

For a standard cash-secured put, the strike price multiplied by 100 shares represents the cash obligation if assigned. That is the collateral requirement, not a guarantee that the position cannot lose more than the premium received.

Assigned shares

Once assigned, I'm exposed to the market value of the shares. The price can fall substantially, including below my effective purchase price after premiums.

Covered calls

A covered call generates premium against shares I already own. However, the premium does not fully protect me from a decline in the stock price. My shares remain exposed to downside risk.

Portfolio-level exposure

I look at the whole portfolio rather than treating each trade as an isolated decision. Several individually small positions can create substantial combined exposure.

8. Managing multiple Wheel positions

As an account grows, it's possible to have several puts and covered calls open at the same time. I want a straightforward way to keep track of what I've committed and what could happen next.

For each position, I would record:

• Underlying stock and sector.
• Number of contracts.
• Strike price and expiration date.
• Premium received.
• Cash collateral committed.
• Current share price.
• Potential assignment obligation.
• Upcoming earnings or other important events.
• Current unrealised profit or loss.

Review the whole portfolio regularly

I don't want to focus only on the premium available from new trades. I also need to review existing positions, the amount of cash remaining and whether my overall exposure still makes sense.

I'd also reassess whether each company still meets my original stock-selection criteria. If its financial position or outlook has deteriorated, the original reason for selling the put may no longer apply.

For more on managing threatened positions, see my Rolling Options guide.

9. Common capital allocation mistakes

Deploying too much capital

Using nearly all available cash can leave me with limited flexibility if several positions move against me.

Chasing high premiums

High premiums can reflect elevated volatility, uncertainty or significant downside risk. A large premium isn't necessarily an attractive trade.

Ignoring correlation

Five positions in the same sector may carry more concentrated risk than five positions spread across unrelated industries.

Using premium to justify an oversized position

A stock should be suitable for my portfolio independently of the premium being offered. I shouldn't increase position size simply because an option looks lucrative.

Failing to plan for assignment

Before selling a cash-secured put, I need to understand whether I could comfortably take ownership of the full 100 shares per contract.

Confusing a reserve with protection

Uncommitted cash gives me flexibility, but it doesn't automatically offset losses or guarantee that I can recover from a large decline.

Concentrating too much in one company

Even if a company offers attractive premiums, I don't want it to become an outsized part of my portfolio. My individual stock limit is there to help prevent that.

10. My capital allocation checklist

Before opening a new Wheel position, these are the questions I'd want to answer:

• Have I defined how much of my account is available for trading?
• Am I keeping an appropriate amount of cash in reserve?
• How much capital will this position commit?
• Does it fit within my individual stock allocation limit?
• Am I already exposed to the same company or sector?
• Could I afford assignment on every contract?
• Would I be comfortable owning the shares if the price fell further?
• Have I considered the company's financial strength and valuation?
• Have I checked earnings and other relevant events?
• Would the portfolio remain manageable if several puts were assigned together?