Trading Options in an IRA

Options trading in your individual retirement account (IRA)? That's something you don't hear about every day. But it's possible in some plans. The ability to trade options in an IRA depends on the account's custodial plan, so check your individual plan's eligibility first. Although you may not be able to trade every single options strategy out there, oftentimes, you're not limited to just one or two. Your choices may include options-only strategies for speculation without owning the stock as well as hedging strategies to use with stocks you buy or already own.

But depending on the trading strategy, you'll need the appropriate level of options trading approval in the IRA. And options aren't appropriate for everyone. So, what can you trade in most Schwab IRAs (not all IRA types are eligible to trade all of the strategies discussed below)? Here are some options strategy dos and don'ts to consider for most Schwab IRAs.

The types of options strategies permitted in a Schwab IRA can vary from one accountholder to the next. Step one is to apply for options approval. If approved, the IRA will be assigned a trading level between 0 and 2.

• Level 0: Covered calls, protective puts, collars, and cash-secured puts¹
• Level 1: Buying calls and buying puts (as well as straddles and strangles²)
• Level 2: Certain spreads³ (verticals, calendars, butterflies, condors, and ratio spreads) if the account is approved for limited margin⁴ 

While understanding the risks to any investment strategy is essential before trading, let's look at three fundamental options strategies that are allowed in Schwab-approved IRAs.

One options strategy that's allowed in some IRAs is a hedging technique that's sometimes used to protect a long stock position from potential losses. It's called a "protective put" (see chart below). As the name suggests, it involves buying a put option—one put option for every 100 shares of stock you own. Typically, the put is out-of-the-money (OTM) meaning it has a strike price below the current stock price.

Buying a put option is often considered a bearish strategy because puts typically increase in value when the underlying 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 you own. Some traders choose a strike price that represents the price at which they'd want to exit the stock to protect any gains or avoid additional losses.

In a worst-case scenario, the losses equal the difference between the purchase price of the stock and the strike price of the put option, plus the cost of the put option (including trading fees). Suppose you bought the stock at $320, and you buy the 300-strike put for $5 with 30 days until expiration. Your 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 your stock. The protection lasts until the put option expires in 30 days.

While the long put provides some temporary protection from a decline in the corresponding stock price, you risk the cost of the put position, plus any losses in the stock down to the put strike price. If the long put position expires worthless, the entire cost of the put option is lost.

On the positive side, if the stock increases in value, you'll enjoy those profits, minus the cost of the put (plus trading fees). If the stock increases by more than the cost of the put, then you'll likely have a profit. With a hedging strategy like the protective put—in an ideal situation, the protection proves unnecessary, and the overall position increases in value.

A "covered call," as you probably guessed, involves a call option. Typically, one OTM (strike price higher than the current stock price) call is sold for every 100 shares of stock. When you sell a call option on stock you own, it's not considered a "naked" sale. You get to keep the premium from the sale—cash in your account—and that can help cushion a small portion of a potential loss in the underlying stock in a down market. However, the position could show losses if the stock falls more than the premium received from selling the call.

If the stock moves above the strike price, the stock will likely be called away and sold at the strike price. This is called getting "assigned." Therefore, unlike holding a stock without a covered call, the profit potential is limited (see chart below).

If it looks like assignment could happen, you could attempt to buy your short call to close the position and 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 use it to try to collect multiple premiums over time. Be aware that short options can be assigned at any time up to expiration regardless of the in-the-money amount. Once assigned, it's too late to close the call option and shares will be called away (sold at the strike price). So, you want to be comfortable with the idea of selling shares before selling call options against a stock position. Also note that rolling a call to a higher strike or later expiration will incur additional transaction fees.

Let's go back to the example of buying the stock at $320 and assume you can sell the 340-strike call for $5 with 30 days until expiration. If the stock price stays below $340 through expiration, you keep the premium (minus trading fees), and after the option expires, you could potentially do it all over again. The more premium you collect, the bigger the cushion if or when the stock drops. If you sell the call OTM (meaning the strike price is higher than the 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.

If protective puts create a temporary floor under the stock, and covered calls can generate income, how about combining the two strategies?

Combining the protective put and the covered call is a strategy called a "collar" (see chart below). As you may have figured out, the collar position involves some characteristics of both covered calls and protective puts. For every 100 shares you own that you want to collar, you'd buy one put option and sell one call option.

For example, the same stock is at $320 per share, a 340-strike call is sold at $5, and the 300-strike put is bought for $5. If you kept the collar until expiration, your $320 stock would be protected below $300, with a "ceiling" of $340 if your call is assigned. The net cost of the collar is zero (you receive $5 for the call and pay $5 for the put), also called "even money," plus transaction fees. You won't always be able to put the collar together with options premiums that completely offset, but if the call and put strike prices are the same distance from the stock price, the premiums can be fairly close. In this example, you have $20 of risk to the downside ($320 – $300 = $20) and a potential profit to the upside of $20 ($340 – $320 = $20).

If you meet your profit target or your loss threshold, you don't need to maintain the position all the way to expiration. You can potentially make adjustments by closing the original trade and opening new positions at different strikes and further expirations. With a collar, there are many ways to adjust your trades as the stock climbs or falls.

One major restriction to trading options in an IRA: You can't borrow money. That may immediately preclude several options strategies, such as:

Short selling: When you sell a stock you don't own, you're selling it short. The short seller's goal is typically to profit if the stock drops in price. If the stock goes up, short sellers lose money. This strategy isn't allowed in your IRA and can affect some options strategies (like the long put, which can result in a short stock position if the contract is exercised and, in some cases, preclude early exercise within an IRA.)

Selling naked: Essentially, this means selling an asset that isn't "covered" by another asset. Hence, naked. If you sell a call (or put) option without covering that risk by buying another call (or put) or a position in the underlying security, the sale is one form of naked selling.

Trading on margin: If you borrow cash from your broker to trade an asset, you're trading on margin. Unlike margin in nonretirement accounts, margin in an IRA is limited and can't be used for short selling, naked options, or to create margin debits. Upon approval, limited margin can be used to trade certain spread strategies and to use unsettled funds for trading.

Trading in an IRA is a new concept for many. So, treat it like you'd treat anything else you're learning for the first time. Because each strategy we discussed is both protective and speculative by nature, take time to evaluate both the risks and potential rewards. Then decide if an approach is suitable for your portfolio.