Trading Options in a Retirement Account

In many cases, investors aren't able to trade options in an individual retirement account (IRA). However, depending on the situation and type of option being used, it might be possible for a qualified trader to add options to their IRA.

Even though there is a reasonable amount of flexibility in an IRA, there are some restrictions on what an investor can include. Here are some types of trades not allowed in IRAs at Schwab.

First, unlike in a margin account (where a trader can borrow against assets and buy more stock than they have cash for), an investor can't borrow money in an IRA to buy stock. When an investor buys more stock than they have cash for, the cash balance becomes negative and interest is paid on the loan against the assets. Investors aren't allowed to use IRA assets as collateral for a loan, so any options trade that requires margin can't be executed in an IRA.

Second, a trader can't short stock in an IRA (and not every stock is available for short selling). Because shorting stock is technically borrowing a stock a trader doesn't own and then selling it, it runs afoul of the rule that prevents investors from using IRA assets as collateral for a loan.

Third, naked short calls aren't allowed in IRAs due to their potentially unlimited risk. A naked short call is one that is not "covered" by any position in the underlying or an offsetting position. Basically, a trader writes a naked short call in an effort to profit from receiving a premium. This limits the upside potential without limiting the downside risk. However, certain strategies that have a short call as a component may be allowed. For example, a trader can sell a call against 100 shares of long stock of the same underlying as a covered call. That reduces the stock's break-even point and limits its potential profit, just as a covered call does in a margin account.

There are some options strategies available in a Schwab IRA. When trading in a Schwab account, the risk management software is designed to reject any trade that would violate the rules.

Qualified traders, whose accounts are approved for options, have access to some strategies they can use in their IRAs. An investor needs to be approved to trade options, plus have at least an options approval level 2 to trade spreads. When approved, an IRA receives "limited margin," allowing for the trade of certain options spreads. It's important to note that limited margin still doesn't allow for the borrowing of funds in the IRA to execute trades. Instead, limited margin is a term that denotes the ability to use expected cash proceeds from unsettled positions to trade certain options.

Covered calls might be used by long-term bulls in an IRA who want to reduce the break-even point of their long stock and want to set up an obligation to sell the stock at a fixed price (known as the strike price) with a specific expiration date. Note, though, that American style options can be assigned at any time up to the expiration date, regardless of the in-the-money amount, so the strategy might not yield the level of profit desired.

A covered call, illustrated below, works by buying stock for cash and selling a call option on the same stock. A standard options contract represents 100 shares of stock, so for a call sale to be "covered," the investor needs to own 100 shares of stock for each call sold. An investor can't sell a call against less than 100 shares, so if there isn't enough cash in the account to cover the cost of 100 shares, the investor could consider using a different strategy.

Instead of buying stock shares, an investor could buy an in-the-money³ Long-Term Equity Anticipation Securities (LEAPS) call. LEAPS have expirations up to three years in the future. Long stock can theoretically go on indefinitely and never expire. But a year out in the future, for example, may be enough time for the LEAPS strategy to work.

For example, if a stock's price is $150, buying 100 shares would cost $15,000. Perhaps that's too much for the IRA. However, the potential LEAPS call at the $120 strike may be $35, costing $3,500. Additionally, the LEAPS option also has a lower maximum risk than the long stock. On the other hand, the LEAPS call will expire eventually and requires the trader to reestablish the position, in addition to being charged commission to maintain the strategy. Additionally, an option could expire worthless, and the total premium would be lost if the stock settles below the call strike at expiration. When using this strategy, traders should also understand that options usually require more active monitoring than stock, especially as expiration approaches. Another consideration is the fact that options trading doesn't come with voting rights or potential dividend payouts, as stock ownership does.

Similar to a covered call with stock, a short call with LEAPS reduces the break-even point of the LEAPS and can generate profit if the stock price rallies.

Shorting the stock—selling the stock without owning it first—is a traditional bearish strategy that can be profitable if the stock drops. However, shorting a stock isn't available in an IRA, so an alternative bearish strategy might be used.

A short call vertical composed of a short out-of-the-money (OTM)⁴ call and a long further OTM call (in the same expiration) is also a bearish trade and allowed in an IRA. For example, if a trader was bearish on the Nasdaq-100^® index (NDX), they might take a short call vertical that involves a short call and a long call If taking a $5 credit for doing the trade, the short call vertical has a maximum potential profit of $500 (not including commissions and fees) if the NDX is below its short call strike price at expiration. Assuming a $10 wide spread between the short and long strikes, there is a maximum loss of $500 if NDX is above the long strike price at expiration (not including commissions). Keep in mind that NDX options are European style, meaning they can only be exercised on the last business day before expiration.

One of the downsides to a short call vertical is the limited profit potential (see risk profile below). Even if the price of the index goes to zero, the maximum possible profit is limited to the credit received for selling the vertical. That's less than what a trader might make on short equity, but the short call vertical has defined, maximum risk no matter how high the index rallies. That's why the short call vertical is allowed in an IRA, while short stock, or short naked calls, are not.

IRAs tend to have longer-term strategies, such as long index funds or portfolios of stocks. And although an investor may have a long-term bullish market outlook, there are times when they might be concerned about a potential sell-off that could negatively impact the IRA. However, an investor might not want to liquidate their long positions. To hedge long positions, they might consider a long index put vertical⁵. Keep in mind that hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss.

If that vertical had a $21 debit, the cost per vertical would be $2,100. That's the long put vertical's max risk too, if the chosen underlying, in this case the index, was above both the long and short put at expiration and both legs expire worthless.

But if the index dropped sharply, the maximum potential profit on that long put vertical is the difference between the long and short strikes minus the debit. If there is a difference of $50 between strikes, that would be $50 minus $21, or $29. That would be $2,900 of potential profit to offset the loss on the long portfolio (not including commissions).

Considering the above example, an investor might base the number of put verticals to buy on potential portfolio loss if the market dropped some percentage. For example, if an IRA had a value of $50,000, and they thought the market might drop 10%, that could create a $5,000 loss. If the chosen underlying dropped 10%, the maximum profit on that long put vertical, described above, is limited to $2,900, no matter how much below the put strike the underlying drops. One put vertical in this situation would offset more than half of the portfolio loss in the scenario of a 10% drop. Buying an index put spread would create a limited hedge and would not provide additional protection though if the price of the underlying drops further.

When using these strategies in an IRA, an investor should manage their risk, pay attention to commissions, and keep the long term in mind.