With IRAs, plenty of stop signs tell you what you can and can’t do with options. Are there workarounds?
Who knew that a nasty “good for you” food like raw spinach made great breakfast smoothies? In the land of reinvention squared, “no” is not a word American investors cozy up to. Like spinach, IRAs (individual retirement accounts) are consumed by millions without too much thought. They’re considered hearty, reliable, and often financially nutritious. Whether it’s you or your boss forking over the dough, IRAs can be used to provide wholesome tax-deferred growth for your future yoga-class budget and are often self-directed—meaning you call the investing shots. One caveat? IRAs and margins don’t typically mix. Considered too restrictive, the accounts are often shunned by active investors and options traders.
But like your excellent downward dog, self-directed IRAs can be more flexible than you think. Let’s review some popular and creative workaround trading strategies that can be used in a TD Ameritrade IRA. They have similar profit-and-loss traits to the strategies that aren’t allowed, while potentially helping you invest for retirement on your terms.
An unlimited-risk strategy like selling uncovered calls (“naked”) requires a margin account and the highest level of options trading approval—something not allowed in an IRA. But wait.
XYZ stock is trading near $100 per share, but every technical indicator under the sun is telling you that the stock is top-heavy and may be slated to go any which way but up. Option premiums seem fairly rich, and you see that the XYZ 100-strike call with 28 days to expiration can be sold for $4.00. You’d love to sell the call option uncovered but, well, you can’t. At least not in an IRA.
Workaround: Sell a Call Vertical Spread
While the 100-strike call may be trading for a significant premium, the call option trading 20% out of the money may be far enough out that it could literally be picked up for pennies on the dollar. Assuming you were looking at January options and are approved to trade spreads in your IRA, your trade might be to sell the XYZ January 100-strike call and buy the XYZ January 120-strike call to create a short-call vertical.
This trade could be placed for a net credit (minus transaction costs) much like the naked-call trade you originally had your heart set on. However, by creating a short 100/120 vertical-call spread, you accomplish several things:
1. You’re able to sell the 100-strike call that you wanted to sell in your IRA.
2. By purchasing the distant 120-strike call at the same time, you create a defined-risk position that takes in nearly the same amount of premium as the unlimited risk position. In fact, you get the same premium for selling the 100-strike call, while only giving back a few cents for the purchase of the 120-strike call, (plus transaction costs).
3. You reduce the potential trade risk from the theoretically unlimited, to just the distance between the strikes (20, or $2,000), less the credit received and transaction costs. In the case of a short spread, the maximum risk is the distance between the strikes—the maintenance requirement you’d need to put up in a TD Ameritrade IRA. In this case, the risk/maintenance requirement is $2,000.
One caveat to consider with the short call vertical is since the short call is at the money there’s a risk you could get assigned should the short call go in the money prior to expiration. This means you would be obligated to deliver shares of the underlying stock that you don’t currently own in the account.
SHORT-CALL VERTICAL VS. SHORT CALL. By replacing the short-naked call position (dash line in graph) with the short-call vertical, you limit your risk and may come close to the same credit received on the short-naked call. For illustrative purposes only. Not a recommendation of a specific investment strategy.
You wonder: can I really trade uncovered short puts without a margin account so long as I secure the sale with cash? Yes. But it’s the amount of cash that may be hard to come by, especially for some of the more expensive stocks out there. Suppose XYZ stock is trading just over $500 per share and you think there’s significant support around $500. Selling just one at-the-money put option contract on a $500 stock, even at an attractive price of say, $25, can set you back nearly $50,000 in requirements.
Workaround: Sell a Put-Vertical Spread
While selling the 500-strike put may bring you a worthwhile premium, it can hurt to have to pay up, in case the stock goes to zero. One way to limit the required funds to sell a cash-secured put is to help out the position by also purchasing a deep out-of-the-money put—something like a 400-strike put. Assuming you were looking at January options, your trade might be to sell the XYZ January 500-strike put; and buy the XYZ January 400-strike put to create a short-put vertical.
Being so far out of the money, the 400-strike put is likely to be trading for a dollar or less. Given the hefty potential premium fetched via the sale of the 500-strike put, having to pony up about a buck, for the 400-strike put (plus transaction costs) seems like a small price to pay, to make the sale of the 500-strike put more affordable. While the sale of a cash-secured 500-strike put at $25 can set you back around $47,500 per contract, by comparison, the sale of a 500/400 put spread at $24 sets you back about $7,600 per contract. This translates, among other things, into either lowering the requirement by about $40,000 per contract, or the ability to enter into a position that is roughly six times larger than what you could afford with just a cash-secured put strategy. Similar to the short call example, since the short put is “at the money” there’s a risk you could get assigned should it go in the money prior to expiration.
SHORT-PUT VERTICAL VS. SHORT PUT. Though short puts (dashed line) are allowed in IRAs if cash secured, putting up the cash for a $500 stock may not be all that attractive. Turning the short put into a short-put vertical gives you a similar bang for a smaller buck. For illustrative purposes only. Not a recommendation of a specific investment strategy.
This one is fairly clear cut. You need a standard margin account to sell stock short—a strategy that makes money as the stock goes down in price—and an IRA does not allow trading on margin or selling stock short. So how can you take advantage of a stock that you think could be heading lower for a sustained period of time?
You could buy a put option. But as you may know, options don’t always change in value at a one-to-one clip with the underlying stock. The average at-the-money option moves at about half the speed of its corresponding stock.
Workaround: Buy Two At-the-Money Puts
If one of something gives you half of what you want, buy two to get the desired result, right? Huh? This is a “math doesn’t lie” scenario at its best. An at-the-money option moves at half the speed of stock because it generally has a 50 delta, meaning it tends to change in value at about half the pace of its underlying stock. That being the case, two at-the-money options would theoretically combine for a delta of 100, thereby creating a position that should hypothetically move one-to-one with the stock.
LONG PUT VS. SHORT STOCK. With nearly the same profit curve at a fraction of the cost of shorting stock, buying puts are allowed in your TD Ameritrade IRA when you want to bet a stock will fall. For illustrative purposes only. Not a recommendation of a specific investment strategy.
What’s better? All other things being equal, because of a put option’s “convexity,” (curved p/l) profits tend to accelerate as the underlying moves lower (with you), while the losses decelerate as the underlying moves higher (against you).
Trading in an IRA naturally has pros and cons. While you can actively manage your portfolio and it allows for earnings to grow on a tax-deferred basis, strategies can be limited by various margin restrictions on certain positions. Fortunately, you can utilize some basic option trades that come close to accomplishing what you need with the strategies discussed here. In an IRA, keep in mind creative options strategies exist if you qualify. And when they’re executed right, concerns may be outweighed by other factors like greater flexibility and new opportunities. If it feels right, consider taking your retirement portfolio beyond its current breakfast menu and trade it outside the (cereal) box.
With $2,000, qualified applicants can open an IRA with option-trading capabilities. If you have a margin account, and don’t have an IRA, consider opening one.
The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.