Roth individual retirement accounts (Roth IRAs) are a popular way to build a nest egg. By paying taxes on their contributions today, investors can avoid paying taxes on capital gains in the future—a good move if they think that their taxes are likely to be higher after they retire.
Of course, Roth IRAs still must follow many of the same rules as traditional IRAs, including restrictions on withdrawals and limitations on types of securities and trading strategies. Below, we’ll take a look at the use of options in Roth IRAs and some important considerations for investors to keep in mind.
- Options give you the right—but not the obligation—to buy or sell the underlying security at a specific price on or before a certain date.
- A Roth individual retirement account (Roth IRA) doesn’t offer an up-front tax break, but the account grows tax free, and qualified withdrawals in retirement are tax free as well.
- Experienced investors can use options in a Roth IRA to hedge risk and generate income.
- Options strategies that involve the use of margin (e.g., VIX calendar spreads) are off-limits in Roth IRA accounts.
What Are Options?
Options are contracts that give the holder the right—but not the obligation—to buy or sell the underlying security at an agreed-upon price and date, known as the expiration date. Every options contract involves a buyer—who pays a premium for the rights granted by the contract—and a seller who “writes” the contract and receives money from the buyer.
The strike price is the price at which the options contract can be bought or sold—or exercised. The difference between the underlying stock price and the strike price determines the option’s value. For example, for call option buyers, the contract is out of the money (OTM) if the strike price is above the underlying stock price. On the other hand, the option is in the money (ITM) if the underlying stock price is above the strike price.
Why Use Options in a Roth IRA?
The first question that investors might ask themselves is, Why would anyone want to use options in a retirement account? Unlike stocks, options can lose their entire value if the underlying security price doesn’t reach the strike price. These dynamics make options significantly riskier than the traditional stocks, bonds, or mutual funds that typically appear in Roth IRAs.
While it’s true that options can be a risky investment, there are many instances where they might be appropriate for a retirement account. For example, put options can be used to hedge a long stock position against short-term risks by locking in the right to sell at a specific price. Meanwhile, covered call option strategies can be used to generate income if an investor doesn’t mind having to sell their stock.
For example, suppose a retirement investor holds a long portfolio consisting of low-cost Standard & Poor’s (S&P) 500 index funds. The investor may believe the economy is due for a correction but might be hesitant to sell everything and move into cash. A better alternative might be to hedge the S&P 500 exposure with put options, which provide a guaranteed price floor for a certain period.
Roth IRA Restrictions
Many of the riskier strategies associated with options aren’t permitted in Roth IRAs. After all, retirement accounts are designed to help individuals save for retirement rather than become a tax shelter for risky speculation. Investors should be aware of these restrictions to avoid running into any problems that could have potentially costly consequences.
Internal Revenue Service (IRS) Publication 590 contains a number of these prohibited transactions for Roth IRAs. The most important of them indicates that funds or assets in a Roth IRA may not be used as security for a loan. Since it uses account funds or assets as collateral by definition, margin trading is usually not permitted in Roth IRAs to comply with IRS tax rules (and avoid penalties).
Roth IRAs also have contribution limits that may prevent depositing funds to make up for a margin call, which places further restrictions on the use of margin in these retirement accounts. In 2023, these limits increase to $6,500 and $7,500, respectively. Note that such limits do not apply to rollover contributions or qualified reservist repayments, however.
Trading Options in a Roth IRA
These IRS rules imply that many options strategies are off-limits. For instance, call front spreads, VIX calendar spreads, and short combos are not eligible trades in Roth IRAs because they all involve the use of margin. In any case, retirement investors would be wise to avoid these strategies even if they were permitted, since they are clearly geared toward speculation rather than saving. Still, IRA investors can generally write covered calls and buy calls and puts.
Brokers also have regulations regarding the types of options trades permitted in a Roth IRA. For example, Charles Schwab requires a balance of at least $25,000 for spread trading. Some brokers may offer restricted margin accounts in which certain trades that traditionally require margin are permitted on a very limited basis.
These strategies depend on obtaining options approval and an options trading level from your IRA custodian. Most brokers have three to six trading levels, with the lower levels allowing lower-risk strategies and the higher ones permitting riskier trades. Therefore, the level at which an investor is approved determines the complexity of the options strategies that they are allowed to use—meaning that some strategies may be off-limits to an investor.
Brokers generally require that traders have knowledge and experience as a prerequisite to trading options, to reduce the likelihood of excessive speculation and risk taking.
What Is a Covered Call?
A covered call is an options strategy where an investor holding a long position in an asset writes (i.e., sells) a call option on the same asset to generate income through options premiums. The investor’s long position is the “cover” because they can deliver the shares if the call option’s buyer chooses to exercise the contract.
How Many Shares Are in an Options Contract?
A standard options contract covers 100 shares of the underlying stock—but the share amount could be adjusted for stock splits, special dividends, or mergers.
What Is a Naked Option?
A naked option happens when the option writer (seller) doesn’t own any (or enough) of the underlying security to meet the potential obligation at expiration. Naked options, which are also called uncovered options, are generally not allowed in individual retirement accounts (IRAs).
The Bottom Line
While Roth IRAs aren’t usually designed for active trading, experienced investors can use stock options to hedge portfolios against loss or generate extra income. These strategies can help improve long-term risk-adjusted returns while reducing portfolio churn.
Of course, safeguards should be taken so that the options do not seem like a mere speculative tool in these accounts. That way, investors can avoid potential problems with IRS rules and assuming excessive risks in funds slated for retirement.