Options trading in your IRA? Read more here about how these options trading strategies can potentially open up some possibilities you never thought existed.
Options trading in an IRA? That’s something investors don’t hear about every day. Some think it can’t be done. But in a word, yes. They can. Although investors may not be able to trade every single options strategy out there, they’re not limited to just one or two. Their choices include options-only strategies that they can use for speculation without owning the stock as well as hedging strategies to use with stocks they own. But depending on the strategy they choose to trade, they’ll need the appropriate level of options trading in their IRA. And options aren’t appropriate for everyone with an IRA.
So what can investors trade in an IRA? Here are some options strategy dos and don’ts to consider.
Let’s start with what investors can’t do—which includes selling stock short, selling naked options, and borrowing on margin.
Short selling: When investors sell a stock they don’t own, they’re selling it short. The goal is to profit if the stock drops in price. If the stock goes up, short sellers lose money. This strategy isn’t allowed in an IRA, but if an investor has their heart set on it, see the sidebar “Can’t Short Stock in an IRA?” for another possibility.
Selling naked: Essentially, this means opening a position by selling options to create a short options position that isn’t “covered” by another asset. Hence, naked. If investors sell a call (or put) option without covering that risk by buying another call (or put), it’s one form of naked selling. There are others. The most well-known is the naked call, where the investor sells a call while holding none of the relevant stock. The investor could be required to sell the stock at any time, but because they don’t own the shares, it would leave them in a short stock position, which is illegal in an IRA. Therefore, selling naked calls is also not permitted in an IRA. Now as a final note, selling a put may be allowed within an IRA if the account also holds sufficient cash to cover the full risk of the position. This “cash-secured” put is considered similar to a covered position.
Trading on margin: If investors have to borrow cash from their broker to trade an asset, they’re trading on margin. We’ll just stop there because this topic is covered in depth in “Basics of Buying on Margin: What Is Margin Trading?”.
None of this precludes investors from using options in an IRA. In fact, they can put several options strategies to work, whether for hedging or speculation. Let’s look at three fundamental strategies.
Buying puts: The first is a hedging strategy that’s used to protect a long stock position from what investors might consider an excessive loss. It’s called a “protective put” (see figure 1). As the name suggests, it involves buying a put option—one put option for every 100 shares of stock owned. Typically, it’s an out-of-the-money (OTM) put, meaning it has a strike price below the current stock price.
Put options are often considered a bearish strategy because they typically increase in value when a stock price drops. But in this context, the profits generated by the put in a down market are meant to offset, to some degree, the losses incurred by the stock an investor owns. When they buy a put, they could choose a strike that represents the price at which they’d no longer be comfortable holding the stock.
In a worst-case scenario, the investor’s losses would be the difference between the price of the stock at the time they bought the protective put and the strike price, plus the cost of the put (including trading costs). Suppose an investor bought the stock at $320, and they buy the 300-strike put for $5 with 30 days until expiration. The investor’s max loss would be $25 per share, plus any trading costs ($320 stock price – $300 strike price, plus the $5 cost of the put). It’s like putting a short-term floor under their stock.
While the long put provides some temporary protection from a decline in price of the corresponding stock, the investor does risk the cost of the put position. If the long put position expires worthless, the investor could lose the entire cost of the put position.
On the positive side, if the stock increases in value, the investor will enjoy those profits, minus the cost of the put (plus trading costs). As long as the stock increases by more than the cost of the put, the investor will have something to show for it.
Covered calls: While it can be tempting to think this strategy is related to the protective put in that it can offer some cushion in a moderately down market by generating income in an IRA, the downside protection is minor and is unlikely to reduce the pain of a loss on a stock position. Instead, the covered call is commonly associated with an income goal. It’s called a “covered call,” and, as you probably guessed, it involves a call option (see figure 2). But this time, the investor would sell the call—typically one OTM (strike price higher than the current stock price) call for every 100 shares of stock. When investors sell a call option on stock they own, it’s not considered a “naked” sale. They get to keep the premium from the sale—cash in their account—and that can help cushion the blow a bit from a small down move in the stock.
At any time prior to or at expiration, if the stock price rises higher than the strike price of an investor’s call option, they could be forced to sell their stock at that strike price. This is called “getting assigned” on the option. Much less common, but still possible, they may even be assigned when the stock price is still below the strike price (“OTM”).
Of course, investors could attempt to buy back the call if it looks like assignment could happen, then sell another call option at a higher strike price with an expiration that’s further out. This is called “rolling out,” and many option traders do this in an attempt to collect premium over time. Be aware that short options can be assigned at any time up to expiration regardless of the in-the-money amount, and rolling will incur additional transaction costs.
Let’s go back to the example of buying the stock at $320 and assume the investor can sell the 340-strike call for $5 with 30 days until expiration. If the stock price stays below $340 through expiration, the investor keeps the premium (minus trading costs) and could potentially do it all over again. The more premium they’re able to collect, the bigger the cushion, which can help if or when the stock drops. If the investor sells the call OTM (meaning the strike price is higher than the prevailing stock price), there’s room for the stock to grow before hitting that strike price.
So, the covered call strategy can limit the upside potential of the underlying stock position because the stock would likely be called away in the event of a substantial price increase. And any downside protection provided to the underlying stock position is limited to the premium you receive.
If protective puts create a temporary floor under the stock, and covered calls can generate income, how about combining these strategies?
Collar: The third strategy combines the protective put and the covered call. It’s called a “collar” (see figure 3) and involves the risks of both covered calls and protective puts. For every 100 shares investors own that they want to collar, they’d buy one put option and sell one call option.
Let’s use the same sample strikes and prices from the earlier example. If the investor kept the call until expiration, their $320 stock would be protected below $300, with a “ceiling” of $340 if their covered call gets assigned. The net cost of the collar is zero (the investor receives $5 for the call and pays $5 for the put plus trading costs), also called “even money.” Investors won’t always be able to put the collar together with options premiums that completely offset it, but if the call and put strikes are the same distance from the stock price, the premiums should be fairly close. In this example, the investor has $20 of risk to the downside ($320 – $300 = $20) and a potential profit of $20 ($340 – $320 = $20).
Keep in mind, there’s no such thing as getting out of a trade too soon—particularly if it’s in a retirement account. IRA options trading is a new concept for many. So investors should treat it like anything else they’re learning for the first time.
If investors meet their profit target or stop threshold (but remember, the stop isn’t a guarantee of a specific price execution), they don’t need to hang on all the way to expiration. Keep in mind, there is no guarantee that investors can close options positions. They can potentially make adjustments by closing the original trade and opening new positions at different strikes and expirations. There are many ways to adjust trades as stocks climb (or fall). Each strategy we just discussed is potentially protective and certainly speculative by nature. Either way, options give active investors—even in appropriately approved IRAs—a bevy of, well, options.
If an investor is bearish on a stock, but they can’t sell short in an IRA, maybe they can consider this. For every 100 shares an investor would like to sell short, they could buy two at-the-money puts. Each put should theoretically move $0.50 for each $1 drop in the stock. So two puts will give the investor a similar profit as a falling stock. The more the stock price drops, the more the profit. If they’re wrong, their losses are limited to the total cost of the put options, so it might be a better risk/return scenario than shorting a stock. Of course, every investor needs to weigh for themselves whether any particular strategy is appropriate for their portfolio.
What investors can’t do:
What investors can do (in an appropriately approved account):