Although individual retirement accounts encourage long-term investing and saving, no rule prohibits short-term trading. Day traders normally buy and sell frequently and exit daily trading without owning any investments. You can shield your option trading from current taxes by using an IRA, but you must follow certain rules.
Option buyers have the right to buy or sell underlying securities or commodities for a set price on or before an expiration date. Option sellers may be forced to sell or buy underlying securities under certain conditions. Option trading varies from low-risk income-producing strategies to high-risk, high-reward gambles. Your trading strategies are limited by the option trading level your broker assigns you. Certain option trades can lose more than your original investment, leading to a negative account balance that is, in effect, a loan from your broker. IRAs aren't allowed to use these trading levels.
The Internal Revenue Service bans you from borrowing from your IRA or pledging it to secure a loan. This means that your IRA can’t use trading margin, which is money a broker lends to help pay for investments. You can make option trades that might result in a negative account balance, but only in a margin account. Therefore, if you day trade options in your IRA, you are limited to trades that your broker permits in a cash account. For example, you can’t sell naked options in an IRA.
The U.S. Federal Reserve Board’s Regulation T prohibits a practice called “freeriding” that occurs when you sell a security in a cash account before you pay for it. This can cramp a day-trader’s style because you must wait three days to receive any money from an option trade. This delay is a result of the three-day settlement period used for U.S. trading. An IRA account is normally allowed to buy securities using money that hasn't settled, even though this is a mild form of margin. Rapid-fire day trading might cause you to buy and sell options with unsettled money, resulting in a freeriding violation.
Example of Freeriding
Suppose you buy an option in the morning and sell it in the afternoon. You then buy another option even though your account’s cash balance is less than the purchase price. You broker will let you to do this based on the money you’ll be receiving when the first option settles in three days. However, if you sell the second option before the first one settles, you've violated the freeriding regulation. Your broker will freeze your cash account for 90 days. You can still trade in a frozen account, but you must shell out the cash upfront.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.