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Options Trading in IRAs, the Benefits and Risks

If you own an IRA worth about $25k or more and are an experienced options investor, think about using a broker that will let you trade options in that IRA.

Options can give you a hedge in volatile markets. Or they can boost your returns. While good markets come and go in the course of an IRA lifetime, the chance to boost returns on retirement money is something no experienced options investor should pass up lightly.

The operating word here is experienced. Don't "learn" to trade options on your retirement money. Investors who are new to options should study the excellent educational materials at the Chicago Board Options Exchange Web site before giving any form of options trading a try. TSC's new book, TheStreet.com's Guide to Smart Investing in the Internet Era, also has a terrific chapter on options contributed by Dan Colarusso, pioneer of this site's Options Buzz column.

If you are options savvy, there are several things to ask your broker if you want to trade in an IRA. The first question is whether the broker offers options trading at all. (As recently as this past summer, Datek didn't.) Second is whether the broker offers IRA accounts. ( Mr. Stock, an online broker that caters to options traders, doesn't.) Third, if your broker allows options trading in IRAs, exactly what trades are permitted? (At Morgan Stanley Dean Witter Online, for example, you can only write covered calls. You can't purchase puts.)

Those brokers that do offer options trading in IRA accounts commonly segment the specific trades they allow into levels or tiers. Writing covered calls, considered the least risky options play, is usually the first tier. Buying puts and calls might make up the second tier, and selling what's known as a cash-secured put makes up the third.

Finally, because of the risks involved, brokers might permit options trading in IRAs only for preferred or veteran customers. If you feel you can make a good case for yourself, by all means argue the point with your broker.

The Risk Factor

Regardless of your experience level, be wary of the special risks of trading options within an IRA. The CBOE has a working paper that discusses these issues and goes over the trading strategies that I'll be talking about here in more detail. Basically the CBOE paper warns that "any option strategy that could result in losses that could not be covered with cash or by the sale of liquid securities held by the account or by amounts which can be contributed to it within permitted levels should be strictly avoided." Put another way: If you mess up, you risk having your IRA disqualified by the IRS and paying a painful penalty as a result. Seek competent tax advice before launching into any form of options trading within an IRA.

IRA Options Strategies

  • Covered Calls
  • Covered calls are one of the more popular IRA options tactics. When you write a covered call, you first purchase shares of a stock. Then you sell (the technical term is write ) a call option on those shares. When you sell the option, you receive a premium from the buyer. In exchange for that premium, the buyer acquires the right to purchase your shares at the agreed-upon price, called the strike price .

    With covered call writing, you get the benefit of holding the common stock while enjoying downside protection equal to the amount of premium you took in. You stand to lose money if the stock declines by an amount greater than that premium. Skilled options traders know when to exit from this sort of losing position. They may simply buy back the option and sell the stock. Because the stock has declined in price, the call option can generally be bought back for less than the price it sold for.

    Instead of selling their stock in the face of a decline, some traders buy back the call, then resell another covered call at a lower strike price and/or with a longer expiration date . These strategies, called rolling down or rolling out, can help minimize losses. That's because the call premiums you receive partially offset the money you've lost in the stock. Options with expiration dates that are farther in the future pay higher premiums. Same goes for call options with lower strike prices. But if the stock continues to decline, it can lock you into a loss. If you see that occurring, it's usually best to quickly exit both the stock and the call position.

    If you decide to write covered calls within your IRA, make sure your broker allows you to buy back that call to close the position. Otherwise you could be forced to hold a losing position until the call expires. While it seems that most brokers, including Ameritrade, Scottrade and PreferredTrade.com, do let you repurchase covered calls to close out your options position, in the past some haven't. So it's something you want to double check.

  • Long Puts as Insurance
  • Some brokers that allow covered calls may also allow you to purchase what are called protective puts. Covered call writers may use protective puts to hedge their positions. Or they may sell covered calls as a way to pay for the protective puts they buy.

    A protective put is really just a standard put option you buy specifically as a hedge against a stock you own but would rather not sell. A put option gives you the right to sell a stock at a specified price by a set date. When the underlying stock declines in value, the put increases in value. When you buy a protective put, you're hoping that any gain in the put's price will offset losses in the stock. However, if the stock surprises you and increases in value, your put option will decline in value. It might even expire worthless unless you sell it beforehand. But, in this case, the losses will be made up for by gains in the stock. In essence, protective puts act like car insurance. If you don't get into a wreck, the insurance expires worthless. But if you do, it can more than pay for itself.

    You can also use protective puts as a hedge against mutual funds. Investors do this by purchasing puts on so-called exchange-traded funds. For example, if you own a biotech fund, you can purchase put options on an ETF called the Merrill Lynch Biotech HOLDR (BBH). The HOLDR contains a basket of leading firms in its sector. When you own BBH puts, if your regular biotech mutual fund declines, in all likelihood, the puts will simultaneously increase in value, and vice versa. You can't write options on all ETFs at present, but the list of optionable ETFs is growing. At the Nasdaq's ETF Web page, if you click on any of the ETFs listed there it says whether they are optionable.

    Also, each Saturday, TSC publishes the ETFs and HOLDRs Weekly Report. Here's the most recent. Be sure to read our primer on ETFs.

    eDreyfus.com is one of the brokerages that lets you buy puts (whether used as a hedge or not) as well as covered call options.

  • Cash-Secured Puts
  • Another strategy that can be even more useful is what's called the cash-secured put. This strategy can be used strictly to generate income, or to acquire stock at a "discount." With a cash-secured put, you sell a put (taking in premium) and give someone the right to sell you the stock at the agreed-upon price. If the strike price is 10, you must place $1,000 on deposit with your broker for each contract you buy, because option contracts each cover 100 shares of stock. If the put is exercised, you'll be required to hand over the $1,000 in exchange for the shares.

    If you're using cash-secured puts to generate income, you're betting that the underlying stock will increase in value and the put will expire worthless, so you get to keep the premium. You may, however, be trying to acquire stock at a "discount" if, for example, you missed a stock's run-up. In this case, you can sell a cash-secured put with a strike price near where you think the stock ought to be trading. If the stock retraces back to that price, the put will be exercised. You get the stock at what you believe is the correct price. And you also get the premium from the put you sold. If, however, the stock doesn't come back down by the put's expiration, you can still elect to purchase the shares, in which case the premium will likewise lower your cost basis. It's a little like buying cereal with a dollar-off coupon.

    If the put is exercised, a few investors then go on to sell a covered call against the stock they've been assigned. This move lowers their cost basis in the shares even further, while generating additional income.

    The online brokerages Brown & Company and Benjamin and Jerald allow you to write cash-secured puts in addition to long puts and calls and covered call writing. The latter brokerage has chosen to specialize in options trading within an IRA. Commissions are fairly steep at $36 for Internet options trades, however. By contrast, Brown & Company charges $25 per options trade.

    Safer Bets

    Some might argue that you don't need to use options to hedge your IRA, because you can enter and exit stock positions without worrying about capital gains taxes. The aggressive nature of options trading can lose you plenty, they'll tell you. A dot-com stock may fall 90%. But long options become totally worthless once they expire. (The same can be said of some dot-coms too, but that's another story.)

    With that in mind, here's a conservative approach to options trading in an IRA. Begin by placing 90% of the account's assets in something safe like Treasuries or a money market fund that might yield around 4.5% annually. Use the remaining 10% of your IRA funds to purchase puts and calls. Skilled options traders can grow the options portion of their IRA portfolios by 100% to 200% or more this way. Meaning, the portfolio as a whole would grow by a respectable 10% to 20%.

    Be aware that you can also suffer a 100% loss with the options portion, but never more than that, because when you buy options, your losses are always limited to the options' purchase price. However, even if you lose the entire 10% of your portfolio used for options trading, the total loss to your portfolio would only be roughly 6%, because you'd still earn a guaranteed 4.5% or more interest on the remaining 90% of your portfolio.

    Mark Ingebretsen, author of the newly released book, The Guts and Glory of Day Trading: True Stories of Day Traders Who Made (or Lost) $1,000,000, has written for a wide variety of business and financial publications. Currently he holds no positions in the stocks of companies mentioned in this column. While Ingebretsen cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to mingebretsen@yahoo.com.

    TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.

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