Last Updated on 16 May, 2023 by Samuelsson
Options trading in retirement accounts is not a commonly practiced approach due to the active nature of options as financial instruments. Additionally, IRS regulations impose restrictions on various forms of options trading within qualified retirement accounts. However, with careful consideration and guidance from financial advisors, options trading can offer value by generating income and enabling the creation of counter-cyclical positions. This article explores the options available for trading in retirement accounts, the limitations imposed, and various strategies to help investors achieve their financial goals.
Understanding Limitations on Trading Options in Retirement Accounts
Retirement accounts are subject to more rules and restrictions compared to standard investment portfolios. These limitations aim to mitigate risks associated with high-risk assets and speculative positions that could potentially lead to debt within the account. Consequently, many retirement accounts impose tight restrictions on selling options contracts. It is crucial to thoroughly review the trading rules specific to one’s portfolio before engaging in any options trading activities.
Exploring Stock Options Trading
While trading stock options directly within a retirement account is limited, investors can incorporate options trading into their overall portfolio through a brokerage account. The most fundamental approach to trading stock options involves buying either a call or a put contract.
Buying a Call: By purchasing a call contract, an investor gains the right to buy an asset at a specified price on or before the contract’s expiration date.
Buying a Put: On the other hand, buying a put contract provides the right to sell an asset at a predetermined price on or before the contract’s expiration date.
For instance, let’s consider the purchase of a call contract with the following details:
Asset: 100 Shares of XYZ Corp. Stock
Strike Price: $40
Expiration Date: August 1
Contract Fee: $50
In this scenario, the investor has the right to buy 100 shares of XYZ Corp. stock at $40 per share from the contract seller on or before August 1. This bullish position allows the investor to profit if the stock price rises, enabling them to purchase the shares below their market value.
A put contract with the same parameters would work inversely, enabling the contract holder to sell 100 shares of XYZ Corp. stock to the investor at $40 per share on or before August 1. This strategy is used when anticipating a decline in the stock’s price, allowing the investor to sell the shares above their market value.
Buying options contracts involves a defined risk since the investor’s financial exposure is limited to the upfront fee paid to acquire the contract. This risk limitation makes buying options contracts similar to buying equities, capping potential losses at the initial investment value. It can serve as a useful diversification tool to safeguard an existing stock-heavy portfolio or amplify an aggressive investment position.
Exploring Covered Calls
A covered call strategy represents one of the basic options positions available in the market. Within a long-term portfolio like a retirement account, this strategy can generate income for an investment that is expected to decline in value or have marginal growth.
The covered call involves buying shares of a stock and simultaneously selling call options on the same stock. By doing so, the investor grants someone else the right to buy the stock at a specified price on or before the strike date.
The shares held act as a cover for the sold options contracts. If the contract is exercised, the investor can fulfill the obligation using the shares they already own. This differs from a “naked call” position, where the investor sells a call option for stocks they do not possess. Most retirement accounts prohibit the sale of naked contracts.
To illustrate, consider the following structure:
Long Position: 100 shares of XYZ Corp. stock purchased at $50 per share
Call Contract: 100 shares of XYZ Corp. stock, strike price $55 per share
Contract Fee: $1 per share
In this example, the investor buys 100 shares of XYZ Corp. stock for a total of $5,000. Simultaneously, they sell a call contract for a fee of $1 per share, generating $500. This results in a total position consisting of 100 shares of stock and a net investment of -$4,500.
If XYZ Corp. stock declines to $40 per share, the investor can maintain a long-term investment stance and wait for its value to potentially recover in the future. In the meantime, they have collected $500 in contract fees, and the call contract sold expires without any value.
Conversely, if XYZ Corp. stock performs well and increases to $60 per share, the investor would be obligated to sell their shares to the contract holder at the specified price of $55 per share. While this limits the potential gains, it also eliminates the risk of having to purchase expensive assets to fulfill the contract. The covered call strategy allows for income generation while accepting the potential limitation on growth.
Understanding Collar Strategies
A collar strategy represents another form of a covered call. This approach involves purchasing a stock, selling a call contract, and simultaneously buying a put contract on the same stock.
The resulting position would look as follows:
Long Position: 100 shares of XYZ Corp. purchased 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
The fees associated with selling the call contract and purchasing the put contract typically offset each other. While the collar strategy does not generate income like the covered call, it serves as an aggressive hedging method.
Selling the call contract eliminates the risk of contract fees but also caps potential profits. Regardless of XYZ Corp.’s performance, the investor cannot sell it for a price exceeding $55 per share. However, the put contract mitigates potential losses, ensuring the investor can sell the stock for a minimum of $45 per share, irrespective of its decline.
Although a collar strategy limits potential gains, it also provides stability and protection against volatility and unpredictable market conditions. This strategy is particularly suitable for investors approaching or in retirement who seek predictability in their account balance over the coming year.
Retirement accounts typically restrict options trading to mitigate risks associated with unlimited exposure, leverage, or naked contracts. While options trading involves inherent risks, it can provide income generation and hedging opportunities for investors aiming to safeguard their wealth for retirement while pursuing high-growth opportunities. It is essential to work with experienced advisors to navigate the complexities of options trading and optimize retirement account strategies.