Trading options in a retirement account is uncommon because options are a fairly active asset and most people take a passive investing strategy when it comes to their retirement accounts. In part, it’s also because IRS rules foreclose most forms of options trading in a qualified retirement account. However options can be a real value-add, as long as you approach options trading carefully, they can both generate income and let you build counter-cyclical positions. A financial advisor can help you figure out the right mix of options trading for your portfolio to help you achieve your individual financial goals.
Limits on Trading Options in Retirement Accounts
Retirement accounts have more rules and restrictions than an ordinary investment portfolio. Most, if not all, retirement accounts limit your trading, which limits your ability to invest in many high-risk assets. Most accounts will also ban margin trading and other forms of leverage. The idea is that these are risky, often speculative, positions that can actually put an account in debt if the investment goes bad. That’s the exact opposite of what the IRS wants to encourage through retirement accounts.
Since options often rely on open-ended commitments, this limits the kind of trading you can do. In particular, many accounts tightly restrict your ability to sell options contracts. Before you start opening any positions, be sure to review the trading rules in your own portfolio.
How to Trade Stock Options
While you may not be able to trade stock options in your protected retirement account, you can still make it a part of your portfolio through a brokerage account. The most basic way to trade stock options is to buy either a call or a put contract.
For example, let’s say you buy a call contract with the following details:
- Asset: 100 Shares of XYZ Corp. Stock
- Strike Price: $40
- Expiration Date: August 1
- Contract Fee: $50
This means that by or before August 1, you have the right to buy 100 shares of XYZ Corp. stock for $40 per share from the person who sold you this contract. This is a bullish, or “long,” position to take. If XYZ Corp. is trading at $45 per share, for example, you’ll effectively make $5 per share by buying the stock for less than it’s worth.
A put contract with the same details would work the other way around. In that case, the person who sold you this contract agrees to buy 100 shares of XYZ Corp. stock from you for $40 per share at any time by or before August 1. Here, you’re betting that the stock price will go down. If XYZ Corp. is trading at $35 per share, for example, you’ll effectively make $5 per share by selling the stock for more than it’s worth.
Buying an options contract is a simpler transaction than selling one because it caps your risk. You pay an up-front fee to buy the contract, and this describes the limit of your financial exposure. If the position has gone bad or would otherwise lose money, you can simply walk away.
In our case above, for example, your risk is $50. You can lose every penny of that if the contract expires worthless, but you can’t lose any more. In this way, buying an options contract has a structurally similar risk profile to buying equities. Your losses are capped at the value of your initial investment.
Buying simple options can be a particularly good way to diversify your positions. If you have invested heavily in a given stock, for example, buying a few put options can give you protection in case the stock goes down. This is called a protective put, and it’s a common way to hedge your investments. Or you can enhance an aggressive position. If you buy call options in a stock you already own, you can effectively double up your investment, betting big on that stock’s success.
How Covered Calls Work
A covered call is one of the most basic options positions on the market. In a long-term portfolio like a retirement account, it can be good for generating income on an investment that you think will decline in value or at best do marginally well.
With a covered call, you buy shares in a stock. At the same time, you also sell a series of call options on that same stock. This contract gives someone the right to buy that stock from you for a given price by or before the strike date.
The shares you hold create a cover for the options contracts that you just sold. If the buyer calls in their contract, you don’t have to create exposure by buying new stock. You can sell them the shares you already own. This is as opposed to a “naked call,” in which you sell a call option for stocks that you don’t yet own. Most, if not all, retirement accounts ban you from selling naked contracts of any type.
The final structure would look something like this:
- Long Position: 100 shares of XYZ Corp. stock, bought at $50 per share
- Call Contract: 100 shares of XYZ Corp. stock, strike price $55 per share
- Contract Fee: $1 per share
You buy 100 shares of XYZ Corp. stock for a total of $5,000. You sell your options contract for a fee of $1 per share, which brings in $500. So you start your total position holding 100 shares of stock and down -$4,500.
Now, say XYZ Corp. decreases to $40 per share. If you are a long-term investor in this asset, this isn’t a problem. You can wait for it to recover its value in the years to come. At the same time, you will have collected $500 in contract fees and the call contract you sold will expire at a worthless value.
On the other hand, say XYZ Corp. does well. The price increases to $60 per share. You will be obligated to sell your shares to the contract holder for $55 per share. You’ll make some money by selling a stock you already own, and can’t lose money by having to go out and buy an expensive asset, although your potential gains are capped at $55 per share.
The risk of a covered call is that you miss out on potential growth. As long as you’re comfortable with that exposure, it can be a good way to generate income for a retirement account.
What Is a Collar?
A collar is another form of a covered call. With this strategy, you invest in a stock. Then, you will sell a call contract and buy a put contract on that same stock. In the end, you would have a position that looks like this:
- Long Position: 100 shares of XYZ Corp. bought at $50 per share
- Call Contract Sold: 100 shares of XYZ Corp., strike price $55 per share
- Put Contract Bought: 100 shares of XYZ Corp., strike price $45 per share
Your contract fees should offset each other. You collect a fee for selling the call contract and spend about the same amount of money buying the put contract. So the collar doesn’t generate income, unlike the covered call. Instead, it’s a way to aggressively hedge your bets.
By selling the call contract, you eliminate the risk of contract fees but also cap your potential profits. No matter how well XYZ Corp. does, you won’t be able to sell it for more than $55 per share. The upside, though, is that the put contract limits your potential losses. No matter how badly XYZ Corp. does, you can always sell it for at least $45 per share.
You can never make more than the call contract allows, but you can never lose more than the put contract guarantees. It’s a stable position for investors who want to protect themselves from volatility and an unpredictable market. In particular, it can be a good option for people in or about to enter retirement. If you want to know how much money will be in your account within the next year, a collar might help you get there.
The Bottom Line
Retirement funds often don’t allow trading options if you have margins, leverage, naked contracts or other forms of unlimited exposure. While these are pretty active positions, they can also be very useful to investors who’d like to build some income or hedges into their portfolios. Trading options can be risky but working with the right experienced advisors can help protect your wealth for retirement while taking advantage of some risky but high-growth opportunities.
Tips for Trading Options
- Should you take a more active role in your retirement account? It’s a good question, and the best person who can help you answer it is a financial advisor, who will help lay out the right financial plan for you. If you’re in need of a new advisor, SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Now that we’ve told you why you might want to trade options, let’s walk through our guide that serves as an introduction to options trading.
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