Trading stock options can be an aggressive, high-risk investment activity, or it can be a conservative, low-risk practice depending on your investment strategy. There is no regulation that prohibits trading stock options in your individual retirement account, as long as your account is self-directed or the custodian of your account permits such activity. The real question is whether options trading is appropriate for your retirement money.
The Internal Revenue Service doesn't provide much guidance on what types of investments are appropriate for your IRA. Instead, it gives you a limited list of things you can't put in your IRA. For example, you can't use money from your IRA to by a life insurance policy. You can't invest in collectibles, such as art, antiques or Persian rugs. The IRS has no prohibition against using money in your IRA to buy stock options, however, as of publication.
Trading Options in Your IRA
Trading options in your IRA, regardless of whether your account is a traditional IRA or a Roth IRA, works the same as trading options in your cash account through your investments broker. You place the order, pay for the transaction, including commissions and fees, with funds from your IRA, and the option is held in your IRA account. If you sell the option, the proceeds from the sale remain in your IRA. If you exercise the option, any stock you acquire is held in your IRA. All of the trades must occur within your IRA to maintain the tax-deferred status of your funds.
Conservative Option Strategies
If you own stocks in your IRA, you can boost their earnings potential by selling covered-call options against that stock. When you sell a covered call, the buyer pays you a premium for the right to buy your stock for a set price, called the strike price, for a fixed amount of time, which is typically one year or less. If your stock does not rise above the strike price, or declines in value, the option will expire unexercised and you'll get to keep your stock, any dividends it paid and the premium. If the price of your stock rises above the strike price, it might be exercised, in which case you sell your stock for the agreed price and you get to keep the premium.
If you are looking for high potential returns and aren't averse to taking some significant risks, you can buy call options in your IRA. When you buy a call option, you are buying the right to purchase the underlying stock at a fixed price for a set period of time. Because there is no limit to how high a stock's price can go, theoretically your profit potential is unlimited. On the downside, if the stock decreases in price, and you are not able to sell your option before the expiration date, the option will expire and become worthless. You could lose your entire investment, which is probably not the best scenario for your retirement money.
If you want to to trade options in your IRA, you'll need to have your IRA with a custodial firm that allows self-directed transactions. The North American Securities Administrators Association notes that approximately $94 billion of the $4.7 trillion held in individual retirement accounts are in self-directed IRAs. With that kind of money at stake, fraud promoters are a real threat. The association advises anyone looking to open a self-directed IRA to check out potential account custodians with a third party, such as the Securities and Exchange Commission before investing any money.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.