The answer, you’ll be glad to hear, is “yes” – but with a few caveats. Here we’ll take a look specifically at what you can and can’t do when it comes to using your IRA to trade and write options contracts.
What Options Can You Trade In An IRA?
You can trade any kind of options contract that doesn’t require borrowing capital from your IRA. This narrows down your choices of options trading to the following two types:
Buying a put option is a hedging strategy that protects you from excessive losses should a particular stock go down in price.
A put option is an out-of-the-money put when its strike price is lower than the current price of the actual stock. When the strike price sits above the share price, the put option is in-the-money.
Put options increase in value when a stock’s price falls, which makes them a bearish investment. However, in this context, the option is being used to mitigate, or offset, the loss resulting from a devaluation of a stock you already own, giving some temporary protection if the market turns against your initial position.
Even if the stock you’re holding goes up in value, the option is still worth paying the premium for – so long as the profits you gain from the rising stock price outweighs the cost of having to buy the put.
This approach involves selling a call option on a security you already own, making it a “covered call“ rather than a ”naked sale“.
When you sell a call option, you get to keep the price of the premium immediately, but run the risk of getting assigned on the trade if the stock price goes higher than that of the strike price.
While covered calls can hamper the upside potential of a stock, the premium you receive acts as compensation should the price fall.
With that said, if it looks like assignment is likely to happen, you can always buy back the call and sell another with a longer expiration time and higher strike price.
What Options Can’t You Trade In An IRA?
There are three kinds of trades that you can’t make with your IRA capital. These are:
Selling naked options:
When you sell an options contract without owning the underlying stock or security, this is known as selling a “naked option”.
This “uncovered” position leaves you vulnerable to adverse price changes since, not actually owning the stock, you do not have the collateral should you have to meet the obligation of the option.
Whenever you “write” an options contract you are agreeing that you will either buy or sell a certain amount of shares at a given strike price on a given date. Any contract of this kind where you cannot cover the obligation is not permitted in an IRA.
If you trade an asset and you have you have to borrow money from a broker to do so, this is classed as trading on margin.
This sort of trading precludes using your IRA, as borrowing on the strength of funds within it is not allowed.
Can You Day Trade Options In An IRA?
Despite the fact that most people use their IRA as a way to save money for the long-term, there are no rules against using an IRA for short-term investments either. This means that for those who want to day trade options with the capital from their IRA, they are perfectly entitled to do so.
However, Internal Revenue Service rules prohibit using an IRA to borrow money from, which means that day traders trading options are not able to do so with a margin account. Any trades you make must come from a cash account held with your broker.
Pros and Cons of Options In an IRA
Using options contracts as a way to make your IRA money work harder in the short-term can be both beneficial and risky.
The benefits include immediate gains from selling options premiums which can be reinvested into your IRA, as well as using the capital funds in your account to mitigate stock positions that you hold elsewhere.
However, the risks of using you retirement savings for speculative trading can be doubly dangerous – if your trades fail, not only do you lose money today, but you lose money which was intended for your retirement many years down the road. And the risks associated with options trading are not trivial, and should only be entered into with full knowledge of all its potential drawbacks.