Options are a type of derivative because they derive their value from the value of other investments such as a stock. An option is a leveraged financial instrument that can fluctuate wildly in value and can lose its entire value within a few months or even days. However, a covered call, which is a type of option, can be sold, or "written," in an individual retirement account as a conservative investment strategy.
A call option gives you the right to buy a stock from another owner at a specific price over a certain period. Each option gives you the right to buy 100 shares of the underlying stock. For example, an IBM April 150 call gives you the right to buy, or "call," 100 shares of IBM stock from another investor at the price of $150 per share, known as the strike price. The April date means the option will expire on the third Friday of April. If the stock underlying your option goes up in value, your option will go up in value, and usually by a much larger percentage. Because call options are considered speculative investments, they are not suitable for the conservative investment design of an IRA. Some firms ban the purchase of options in an IRA account.
Selling a covered call option can transform an aggressive speculation into a conservative investment. Normally, if you sell a call option you give another investor the right to buy stock from you at a certain price. This can be extremely risky because if the stock price rises dramatically and the investor exercises the call option, you will have to buy the stock at a theoretically unlimited price to give it to the call owner. However, if you already own the underlying stock, that call option becomes "covered." If the call buyer exercises his option, you simply hand over the stock you already own, rather than having to buy it at a high price in the open market. Many firms allow investors to sell covered calls in an IRA.
Selling covered calls is primarily an income-generating strategy. When you sell a call option, you receive a payment known as a premium. Depending on market variables, including the price of the underlying stock and the time to expiration, the premium you receive could vary from a few cents per option to hundreds of dollars. No matter what happens to the stock, you get to keep this premium. If the stock moves up in value above the strike price of the option, the option buyer will usually call the stock away from you at the strike price. If the option expires worthless, you get to keep the premium and the stock. Selling a call is also a hedge against the value of your stock going down.
The main risk in writing covered calls is the loss of the underlying stock at a below-market price. For example, if you write an October IBM 140 call and the stock climbs to $200 per share, you are obligated to sell the stock to the call buyer at $140 per share. You do not participate in the gain of the stock from $140 to $200. However, because you are selling the option rather than buying it, you don't risk any additional capital.
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