Options are contracts that permit an investor to buy or sell stock or another security at a fixed strike price. Internal Revenue Service rules for individual retirement arrangements, or IRAs, don’t say anything specific about options. IRS rules, however, prohibit borrowing for IRA transactions, so you cannot engage in any options trade that require borrowing. Trading options can involve high risk, as options are good for only a limited time. If you can't exercise options to make a profit before they expire, you lose all of the money you invested. Consider consulting a financial adviser before pursuing this investment strategy.
Before you can include options in an IRA, a broker must approve you for trading these investment instruments. Not all brokerage firms allow options trading with IRA accounts. You’ll need to open a self-directed IRA account with a broker that permits IRA options trading. “Self-directed” simply means that you make the investment decisions for the money in the IRA. Because trading options is risky, you may have to show you have some experience investing before being approved.
IRA Borrowing Prohibition
Due to the IRS prohibition on borrowing with IRAs, some forms of options trading are not allowed. Selling naked calls or naked puts, which are contracts not secured by assets you own, are two actions that wouldn't be permitted with IRA funds. Breaking this rule can be very expensive: The IRS may disqualify the entire IRA, and all of the money in it would become fully taxable in the year the prohibited transaction occurred. You may have to pay penalties as well.
Calls and Puts in IRAs
You can buy call and put options with an IRA. Calls confer the right to buy shares at a guaranteed strike price. If the price per share rises above the strike price, you purchase the shares by exercising the option and then sell them at the higher market price. Puts give you the right to sell shares at a guaranteed price. If the per-share price drops, you can buy the shares at market price and use the put option to sell at the higher strike price. These transactions don’t involve borrowing so do not conflict with the IRS rules governing IRAs.
Writing Options Using IRAs
You can sell options contracts instead of buying them. This is called writing options, and two types are allowed with an IRA. In a covered call, you write a call option and buy shares of the stock so you have them on hand if the option is exercised. In a cash-secured put, you sell a put option and keep enough money in the IRA to buy the shares if the put option is exercised. With both covered calls and cash-secured puts, you own the asset you have to deliver when options are exercised. No borrowing is involved, and thus you haven't violated IRS rules for IRAs.
Options as Insurance
You can use options to reduce the risk of other investments made with IRA money. Suppose you own 100 shares of Company XYZ stock that is trading at $50 per share. You aren’t ready to sell the stock, but you don’t want to risk taking a big loss if the share price takes a nosedive. You can buy a put option with a strike price near $50 per share. Essentially, the put option insures the $50 price at the cost of paying a premium.