You’re chillin’ in the heat of summer, “Julying” by the beach, or maybe just cranking the AC and taking a nap. You’d think an individual retirement account—your good old IRA—is the investing analogy to your dog days. Kind of slow. Kind of lazy. But just like getting off the beach blanket and sticking your toe into a relatively cold ocean, a qualified trader can perk up her retirement investing inside a retirement account. Taking the plunge has a few limitations. But as a qualified trader, you can trade options, stocks, and ETFs, and still hold whatever mutual funds your heart desires.
Why do this?
Flexibility. Long mutual funds usually found in IRAs are typically 100% long stock or bonds. You’re in or you’re out. But if you want to broaden your portfolio with different strategies to potentially increase returns and/or reduce risk in an IRA, read on.
For starters, the ground rules. Retirement accounts have certain restrictions. Let’s look at a few things you can’t trade.
First, unlike in a margin account (where you can buy more stock than you have cash), you can’t borrow money in an IRA to buy stock. With a margin account, when you buy more stock than you have cash for, your cash balance goes negative and you’re borrowing on margin. In an IRA, this is verboten because you can’t use IRA assets as collateral for a loan.
Second, you can’t be short stock in an IRA for basically the same reason. When you short stock, you are technically borrowing the stock you don’t actually own and then selling it. But you can’t use an IRA as collateral against borrowed stock.
Third, in an IRA you can’t be naked short calls, because a short call has potentially unlimited risk. What qualifies as a naked short call? Any short call that doesn’t have 100 shares of long stock against it, or another long option in the same, or further, expiration. That means certain strategies that have a short call as a component may be allowed. For example, you can sell a call against 100 shares of long stock as a covered call. That reduces the stock’s breakeven and its potential profit, just as a covered call does in a margin account.
Don’t get hung up on the restrictions. There are still lots of strategies you can explore in an IRA. And the nice thing about trading in your IRA is that the risk management software will reject any trade that would violate the rules. That means you can stay focused on what’s possible.
You Have Choices
Let’s look at three IRA scenarios for trading options. It’s not an exhaustive list, but if you’re a qualified trader, the following ideas can get you thinking about how to use options to express market bias while still following the rules.
1. Stock replacement with a covered call
Covered calls can be considered a standby strategy for long-term bulls in an IRA who want to reduce the breakeven point of their long stock (Figure 1). You buy the stock for cash and sell a call against it. Simple. But what if the cost of 100 shares is more than the cash in your account? You can’t sell a call against less than 100 shares. Do you have to abandon the stock? Not with options.
Figure 1
Instead of buying stock shares, you could buy an in-the-money (ITM) long-term equity anticipation securities (LEAPS) call. LEAPS have expirations up to three years in the future. Now, long stock never expires. But a year out in the future, for example, may be enough time for the LEAPS strategy to work. A long ITM LEAPS call that has a delta close to 100 will approximate the risk profile of long stock but may have a smaller price.
For example, if a stock’s price is $150, buying 100 shares would cost $15,000. Maybe that’s too much for your IRA. But let’s say a LEAPS call at the $120 strike is $35. That would only cost $3,500. So the LEAPS option also has a lower max risk than the long stock. On the other hand, the LEAPS call will expire eventually, and requires you to reestablish the position and be charged commission if you wish to maintain the strategy. An options position also requires more active monitoring than stock.
Just like selling a call against long stock, you can sell a call in a closer expiration against that long LEAPS call and have it “covered,” just as if you bought stock. Just like the covered call with stock, the covered call with the LEAPS reduces the breakeven point of the LEAPS and can generate profit if the stock price rallies. Guess what? You can do all this in an IRA.
2. Bearish strategy with verticals
You think a stock’s going down? Shorting the stock—selling the stock without owning it first—is a traditional bearish strategy that can indeed be profitable if the stock drops. But remember, you can’t short stock in an IRA. What’s an alternative bearish strategy?
A short call vertical composed of a short out-of-the-money (OTM) call and a long further OTM call is also a bearish trade and allowed in an IRA. For example, if you were bearish on the NDX at $6,800, a short call vertical could be short a 6900 call, and long a 6910 call. Let’s say you take in a $5 credit for doing that trade. That short call vertical has a max potential profit of $500 if the NDX is below $6,900 at expiration, has a breakeven point of $6,905, and a max loss of $500, if NDX is above $6,910 at expiration (not including commissions).
The downside to a short call vertical? It has limited profit potential (Figure 2). Even if the price of the stock goes to zero, the max possible profit is limited to the credit you get for selling the vertical. Now, that’s less than what you might make on short stock, but the short call vertical has defined, maximum risk no matter how high the stock or index rallies. That’s why the short call vertical is allowed in an IRA, while short stock, or short naked calls, are not.
Figure 2
3. Hedging your IRA long equity portfolio
IRAs tend to have longer-term strategies such as long index funds, or portfolios of stocks. And although you may have a long-term bullish market outlook, there are times when you might be concerned about a potential selloff that could hurt your IRA. You don’t necessarily want to liquidate your long positions. But if you’d like to hedge them, consider a long index put vertical. Yes, you could potentially sell OTM call verticals in an index. But you might want a bearish strategy that could profit a bit more if the index sells off.
For example, with the NDX at $6,800, a long put vertical that might hedge a long portfolio would be long a $6,820 put, and short a $6,770 put. 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 NDX was above $6,820 at expiration.
But if the market crashed and the NDX dropped sharply, the max potential profit on that long put vertical is the difference between the strikes ($50), minus the debit ($21), or $29, if the NDX is below $6,770 at expiration. That would be $2,900 of potential profit to offset the loss on your long portfolio (not including commissions). So, this long put vertical potentially has more “hedging power” than a short call vertical.
But how many put verticals would you buy? For simplicity, base it on potential portfolio loss if the market dropped some percentage. For example, if your IRA had a value of $50,000, and you thought the market might drop 10%, that could create a $5,000 loss. If the NDX dropped 10%, the max profit on that long put vertical is $2,900. One NDX put vertical would offset more than half of the portfolio loss. Using one single index vertical will have lower commissions and execution costs than alternative hedges, such as buying many verticals on each of the IRA components or lower-priced index ETFs, or even multiple short index call verticals.
See? There’s a lot you can do in an IRA. As long as you manage your risk, watch out for commissions, and keep the long term in mind, options might be able to help you jump-start your retirement savings.
If you like the sound of options, but your retirement assets are in a 401(k) that doesn’t allow any options trades, consider rolling that 401(k) into an individual IRA and keep it tax-deferred. Then you can take advantage of all the tools and know-how provided. Just keep in mind that not all traders qualify for options trading.
Courtesy: The Ticker Tape, ThinkMoney authors of TD Ameritrade