Two Option Strategies for an IRA
Options and Your Retirement Account
Options were invented to reduce risk. They work by transferring risk from the risk adverse trader to a risk taker. By accepting specified risk, the risk taker (option seller) is paid a cash premium by the risk avoider.
Options are an excellent investment tool for your retirement account because you can take either side of the risk curve. If you are an investor who typically buys stock, options offer additional money-making opportunities.
- You can sell options and collect a cash premium. This strategy establishes a limit on how much money you can earn from the position. This strategy produces modestly higher profits over the longer term -- and especially when stock prices are falling, holding steady, or rising slowly.
- Option buyers can own a position that is very similar to owning stock, but they invest a fraction of the cash. That reduces the rise of incurring a large loss when the stock market tumbles. NOTE: If you do buy options, I recommend only buying options that are in the money.
Specific Strategies for an IRA (Individual Retirement Account)
The strategy: Sell one call option, granting another person the right to buy 100 shares (that you already own) of a specific stock at a specific price -- but only for a limited time.
When you own stock, the dream is for the stock price to move higher, increasing the value of your investment.
The risk for a covered call writer is that the stock price will undergo a substantial price increase and you will be forced to sell your stock at that previously agreed-upon specific price (the strike price).
When you own stock, the risk is that your investment will fail to increase in value or even worse, decline in value.
When adopting this strategy, you collect cash when selling the call option. That cash is yours to keep, no matter what else happens. Therefore, when the stock price does not increase, you not only hold onto your shares when the option expires, but that cash becomes your reward (profit) for owning the stock. If the stock price declines, then the cash is used to offset all, or part, of that loss. In other words, your profit potential may be capped, but, in return for accepting that risk, you can expect to earn a profit more often. And any loss is reduced by the premium collected. Conclusion: More profits, fewer and smaller losses -- both can be yours when you agree to accept a limit of the potential profit available.
To summarize: Writing covered calls is appropriate for any trader who wants to earn more frequent profits and who is willing to limit profits. Thus, it is not for everyone. It is also a very poor strategy choice for the greedy investor who expects to earn the maximum possible sum from every trade.
The strategy: Sell one put option instead of buying 100 shares of stock. Collect a cash premium. Two results are possible (when you do not make any other trades before the option expires).
- The option expires worthless. Your profit is the cash premium collected when selling the put.
- When expiration arrives, the stock price is below the strike price of the put option. You are assigned an exercise notice and are obligated to buy 100 shares of stock at the strike price. Your net cost per share is the strike price minus the option premium. Note: This should be an acceptable result because you should never sell a put option on a stock that you are not willing to own.
By selling the put option, you accepted risk: The stock price may tumble, requiring that you buy the shares at a price that is substantially higher than the true market value of the stock.
Note that this is the identical risk for every investor who owns stock and is not specific to people who sell put options. In fact, selling puts comes with reduced risk because your stock purchase price (for those times when you do buy the shares) is lower than the investor who buys shares instead of selling puts.