Using options can be a great way to maximize the returns in your individual retirement account (IRA). However, if used incorrectly, trading options can lose you money quicker than another economic crisis. With this in mind, investors should operate with a few simple rules to ensure you are using options safely and to their full potential.
First of all, under no circumstances should out-of-the money calls (or puts) be purchased in an IRA. The reality is that the vast majority of out-of-the money options end up expiring worthless. These options are used primarily for speculation purposes, or for hedging long or short positions. For example, let's say I buy 500 shares of a company that has a very real chance of going to zero, for example, First Solar (NASDAQ:FSLR). It's one of my favorite companies, but going out of business is certainly plausible, given the instability of the sector. I could then buy five very out-of-the-money puts in order to protect myself should the stock rapidly lose value. While this kind of strategy definitely has its place in the investment world, speculation like this has no place in your retirement account.
Second, buying calls is acceptable if used correctly as a stock replacement strategy. What I mean by this is that instead of buying an expensive stock like Apple (NASDAQ:AAPL), an investor could choose to stretch his/her money by purchasing a deep-in-the-money call instead. For example, if I were to buy 100 shares of Apple at Thursday's (10/4/2012) close, it would cost me $66,680. Instead, I could choose to buy a January 2015 $400 call, which is currently trading for around $292.00, for a total investment of $29,200. Even the most bearish analysts agree that Apple isn't going down to anywhere near $400 anytime soon, so effectively, this strategy allows you to benefit from any upside of 100 shares of Apple between now and 2015, for only 43.8% of the cost of buying the stock outright.
If Apple is worth $850 at expiration, for instance, the 100 shares of stock would be worth $85,000, which would be a 27.5% gain. The call option would be worth $45,000, which is a 54.1% gain. So, a stock replacement strategy can be an effective tool for long-term investing. However, it is important to note a couple of points. First, make sure you buy an option that is well into the money, to the point where there is almost no chance of the stock going that low again. Also, a downside of this strategy is that as an option holder, you are not entitled to any dividends. This is fine for a stock like Apple, which pays only a 1.58% dividend or Google (NASDAQ:GOOG), which doesn't pay a dividend. It would not be appropriate for replacing a high-paying stock in your portfolio, like AT&T (NYSE:T) or Verizon (NYSE:VZ), which pay in excess of 5%.
Finally, use covered calls with caution. I am very adamant about the value of using covered calls and selling puts in your IRA. However, there are a few rules to follow to use them properly. Only sell puts on stocks you wouldn't mind owning if the price came down. Selling puts can be a great way to get into stocks at a discount during dips in the share price, but don't sell puts simply because you think the stock will never go down.
And lastly, when selling calls, make sure the strike price is far enough out of the money that it has a very slim chance of being called away, or if it is called away, that is it worth it. Far too often, investors will sell a call with a strike just above the share price (i.e. a $50 call on a $49.50 stock), because it commands a high premium and looks like easy money. It isn't. If that stock jumps up to $52, which almost any stock could do in a good week, you only get to keep 50 cents of the upside. If you sell a $55 call on a $49.50 stock, and the share price shoots up to $58 in a week, you still pocket a gain of over 12%, making the risk of losing upside worth the income the calls generate.
Disclosure: I am long AAPL, FSLR, T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.