Seeking Alpha

Options Strategies And Your IRA Account

by: Reel Ken
Reel Ken
Medium-term horizon, long-term horizon, investment advisor

I receive many responses from readers of my option strategy articles. Recently one question keeps popping up, though in various forms. Do these strategies work with IRA accounts?

The simple answer is YES, to an extent. In some cases options actually work better in an IRA than in a taxable account.

One of the most common option strategies is the selling of a naked put instead of actually buying the underlying stock. The taxation of gain on any security (including options) that is sold short is at ordinary income rates. In an IRA this doesn’t matter as there is no current tax and all distributions are taxed at ordinary rates regardless of their initial source. So, from an IRA taxation standpoint there is no difference in selling puts and buying stock (though there may well be a difference in investment result).

In a taxable account the same doesn’t necessarily hold true. If you hold a stock long enough the dividends and any gain can be taxed at the lower long-term capital gains tax rate. Shorting a put is always taxed at ordinary rates and can be significantly higher. This is a factor that can reduce your net after-tax yield and should be factored into your planning.

Putting taxation aside, there are several limitations in IRA accounts you need to deal with. First is the margin account. Your IRA must establish a margin account if you are going to employ any strategy other than simply buying calls or puts. This is generally not a big deal but does require proper trading authority from the compliance department of your broker.

The simplest level of authority allows the selling of covered calls. This is really more of a stock strategy than an option strategy but I include it.

Next is the selling of “cash secured puts”. This is relatively easy to understand. Let’s say you want to buy 1000 shares of a stock trading at $15. This would require $15,000 in cash. Instead of an outright purchase you could chose to sell 10 puts (each put controls 100 shares). Your exposure is no greater than having bought 1000 shares for $15,000 and you need only “reserve,” or set-aside $15,000 of cash to enter this transaction. In essence, there is no leverage.

This is different than margin in a taxable account that can require as little as 25% in margin. Taxable margin accounts increase the leverage as much as four-fold. This is either good or bad, depending on which side you land on.

An additional limitation in an IRA account is the prohibition against short selling. Selling “naked calls” is similar to shorting the underlying and prohibited in IRAs. In a taxable account you can sell naked calls and just need to deal with margin requirements.

This means that those strategies that include selling naked calls can’t be used.

Strategies so limited include straddles, strangles, synthetic shorts and other derivations. Let’s say you wanted to sell a “straddle” on a particular underlying stock. This would require you to sell a put and a call at the same strike (usually at the same expiry, but not required). In a taxable margin account this would be permitted. The trade is “paired” and the margin requirement is computed on just one of the legs: the larger of the two.

This can be a very useful tool when a trade entered by selling a put turns against you. Selling a call can offset or reduce further losses. You use little or no margin. This can’t be done at all in an IRA margin account as a naked call can’t be paired with a put (it can be paired only with a long call).

Some readers might just “zone out” when talk turns to straddles and strangles. They often understand what they are but might not really understand how they can be used. Straddles and strangles can provide one of the easiest and most productive hedges available. Readers may want to review my article on using a strangle to hedge XLE to see these strategies in action. Unfortunately this technique isn’t available in IRA accounts.

This leads us to the available option strategies---spreads. Included in these are calendar spreads, diagonal spreads, vertical spreads and certain butterfly and condors that fully pair options. This requires a higher trading authority.

Let’s examine a vertical bull put spread to see the advantage of this higher trading authority. This strategy consists of selling a put at one strike and buying a protective put at a lower strike (both with same expiration). An example would be a stock trading at $25. You could sell 10 out-of-the-money puts with a strike of $24 and buy 10 protective OTM puts with a strike of $20.

If you did not have the higher trading authority it would break down as two separate transactions. 1) a cash covered put requiring $24,000 in reserve ($24 times 1000 shares) plus 2) a cash buy of the lower strike put. With the higher authority the margin requirement is simply the difference in strikes ($4) times the number of shares (1000) or $4,000.

Many of my portfolio strategies consist, in part, of buying far dated options and selling near dated or weekly options (calendar spreads). These spreads are all permitted in an IRA account and one need only take into account available margin balances. The IRA margin calculation for a calendar spread is the same as the vertical put. It is just the difference in strikes times the shares. So, if you bought 10 September OTM calls at $24 and sold 10 OTM December calls at $19 your margin requirement is $5000 ($5 strike differential times 1000 shares).

If you sold a call at a higher price than the one you bought, there is no margin requirement, just cash. It is viewed very much the same as a covered call.

Additionally, if you sell a put at a lower strike than the one you bought there is no margin, just cash.

Whenever spreads are used in an IRA account a trading complexity can exist.

Let’s say your IRA had $100,000 in total value broken down to $60,000 in stocks and $40,000 in cash. Let’s further say you wanted to enter into a bull put spread for 10 options on SPY (currently trading at $125). You sell ten OTM puts at a strike of $123 and buy ten protective OTM puts with a strike of $120. Your margin requirement is only $30,000 ($3 strike differential times 1000 shares) and well within your cash balance.

A snake lays waiting for you in the brush. Let’s say SPY drops and your ten puts are assigned. This means 1000 shares are bought at $123 for a total cost of $123,000 and you only have $40,000 in cash.

This isn’t too big a deal in traditional margin accounts as you can use margin to sell the shares. It doesn’t work that way with IRA margin and this presents a problem that may require you to liquidate other securities and suspend your trading privileges. You need to discuss how your broker will handle this to be sure you aren’t further restricted.

This requires constant monitoring of the extrinsic value of the option to determine its likelihood of assignment. When the extrinsic approaches just a few cents the assignment likelihood increases. If the likelihood is great, you need to pre-mpt the assignment by rolling the option beforehand. If you just use cash secured puts you never have to worry about assignment as there is always enough money to cover the assignment.

A similar problem can occur if you sell a call as part of a paired strategy and the call is assigned. You end up being short the underlying. Since IRAs can’t be short you need to cover the short immediately and need enough cash in your account to do so. If you don’t have enough cash you may encounter a trading violation and that restricts your future trading.

When various spreads allow you to trade options with a “sticker price” in excess of your account value (leverage) you need to monitor them carefully to make sure they aren’t assigned.

In conclusion, if you can secure the necessary trading authority many of the option strategies will be available to you. Margin requirements will restrict some of the leverage available when compared with taxable accounts. Assignment can also become a greater problem than a taxable account and requires monitoring. These are not major obstacles, but ones that need to be kept in mind.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.