Options in an IRA: Are they ever safe?

Trading options in a retirement account such as an IRA may be possible, but is it a safe thing to do? Experts generally advise against trading options in an IRA because of the high risk involved. That said, retirement investors may consider using a few option strategies in limited situations.

Here’s how trading options can be so dangerous in an IRA and when you might safely do it. 

Do options make sense in a retirement account?

Trading options is one of the riskiest things you can do in the financial markets. Yes, options have the potential to make a significant amount of money, but they have the potential to lose just as much. That’s not something that financial advisors recommend for an IRA, which should be invested in tried-and-true strategies such as a diversified portfolio of stocks and bonds. 

“This isn’t something you can hear about on social media and jump into expecting immediate success and without fully understanding the risks,” says Greg McBride, CFA, Bankrate chief financial analyst. 

And the risks with options are legion. Those aiming for a moon shot are looking to buy options — either call options or put options — because they can multiply in value quickly on small changes in the price of the stock. That’s because options take advantage of the power of leverage, and the buyer is paying for a stock’s returns beyond the option’s strike price but only for a limited period. If the stock moves unfavorably, the option could end up worthless in just weeks or months. 

That kind of risk is not something that should be in a retirement account meant to fund your golden years. If you’re looking to multiply your money, you have the ability to do that with alternatives that have done well over time. For example, S&P 500 index funds have returned about 10 percent per year on average over the long term, providing a solid return to investors who hung on for the ride. 

“Options trading, especially in a retirement account, is something for more experienced investors that are comfortable with hands-on trading,” says McBride. 

Options require active management and plenty of time and attention. You can’t sit back with options and invest passively and successfully, as you can do with stocks and exchange-traded funds (ETFs). Instead, options have to be actively managed, and because they eventually expire, they need a trader’s careful attention, or a small fortune in options may end up worthless.

Still, a few options strategies can make sense in a retirement account if they’re used carefully.

What options strategies make sense in a retirement account?

Investors looking to use options in a retirement account with lower risk have at least a couple strategies that can be effective. These strategies both involve selling options — rather than buying them, as above — and they both generate cash, making them even a slightly better fit for an IRA, since the income is not immediately taxable there. In fact, these two strategies are relatively popular among retirement investors because they produce income with reduced risk.  

Covered calls

A covered call is a strategy that can generate regular cash over time and has a limited risk. A covered call involves selling a call option on a stock that you already own, and you’ll sell one call for every 100 shares of the stock you own. You get cash upfront, but you’re obligated to sell your stock at the option’s strike price if the stock exceeds the strike price at the option’s expiration. If it doesn’t exceed the strike price, you keep the stock and can re-up the trade again and again.

Even if the stock does exceed the strike price, your potential loss is capped, since the loss in the option is completely offset (at expiration) by the gain in the stock. You end up losing only money that you otherwise would have made. That’s still a real loss, but your stock position protects you. 

If the stock is called away, you can re-buy the stock after the option settles and sell another call option. Again, inside the protection of the IRA, those capital gains are not immediately taxable. 

The best brokers for options trading can help you analyze and sometimes even visualize the risks and potential reward of your option trade.

Cash-secured puts

A cash-secured put is another basic option strategy that can work effectively in an IRA. This strategy involves selling a put option while maintaining the cash on hand to purchase the stock if it’s put to you. You’ll sell one put for every 100 shares of stock that you would want to own. You get the cash upfront, but you’re required to purchase the stock at the option’s strike price if the stock is below the strike price at the option’s expiration. If the stock doesn’t fall below the strike price, you keep the cash and can perform the strategy over and over. 

This strategy is much like insuring a stock against loss below a certain price level for a set period of time. But much like an insurance company, you could lose more than you made from the premium if the stock falls too far. You could also think of a cash-secured put as a way to buy a stock at a better price if it reaches a certain level. Either way, you’ll get the cash from selling the put inside your IRA, so you won’t owe any taxes on it immediately. 

IRA investors: Keep your options exposure low

Both of these methods have the potential to have the options exercised against you, forcing you to make good on the promise to buy or sell the underlying stock, depending on the type of option. But either way, you want to be careful how much exposure your portfolio has to options. 

“Even the savvier, experienced investors that trade options will only use a portion of their account balance for this endeavor, often as a hedge or a way to supplement the returns on the broader portfolio rather than a ‘swing for the fences and hit the lights out’ approach,” says McBride. 

Both of the strategies above can offer safer returns than a strategy that involves buying options. But even still, you want to take a measured dose of options. If you sell calls against a whole position and it moves up significantly, you could lose a lot of money that you otherwise would have made. 

The situation may feel worse with a cash-secured put. If the stock drops significantly, you could lose several times the amount of the premium and may lose 10 times or more, depending on the terms of the trade. It won’t feel good if that money is vaporized from your retirement account.

So it’s important to keep your options exposure modest unless you really know what you’re doing and are prepared to live with any adverse consequences. The risk may not be worth the reward.

Bottom line

While you can do just fine by keeping your IRA confined to a diversified portfolio of stocks, investors do have a few limited circumstances when it could make sense to add some options strategies to the mix. But it’s important to fully understand the risks you run and keep your exposure low.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.