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Not many people will consider options trading in an IRA. Most retirement accounts are only exposed to conservative or incredibly safe investing strategies. Investors looking for a bit more return in their investment may consider approaches like selling covered calls in their IRA but is it possible?
You can sell covered calls in an IRA. In a covered call, your position is covered, and the only real risk is having your shares purchased at the “strike” price.
However, you will need to have options trading approved from your brokerage to sell covered calls in an IRA since you are trading options. Typically this is a simple form you have to fill out either in your local branch or online.
In this article, you’ll learn more about selling covered calls in an IRA, including the advantages and the disadvantages.
Selling Covered Calls In an IRA
Selling covered calls in an IRA is a double-sided strategy that involves selling calls on stocks in your IRA on a 1-1 basis. It requires you to buy the stocks first, (or already have them in your portfolio) and sell calls at the same time.
Selling covered calls is one of the more conservative approaches to use in the otherwise volatile world of options. Since you already own the stock in question, your position is protected (covered), and the only real risk is having your shares purchased for the strike price.
You collect the option premium when you sell your call. If the stock’s value rises above the strike price, you can either buy back the call or wait for the option to be exercised on expiry.
Of course, the option expires worthless if the stock’s value remains below the strike price, and you get to keep the premium and then sell another call again (if you choose).
The Legality of Options Trading in an IRA
You can legally use selling covered calls to generate a little more return on stocks you already own. There’s no complete ban on options trading in IRAs.
The one limitation is that margin trading is not permitted, so all strategies involving margin aren’t allowed.
For example, if you sell a “put,” the buyer has the right to sell a stock to you at a specified strike price. If the put is exercised, you’ll need to borrow or front enough money to buy the stock.
The total amount (including the borrowed sum) will likely exceed the annual contribution limit for your IRA account.
There’s no margin involvement in selling covered calls. You’ll only be obligated to sell shares and not buy them—because you already own them.
Advantages of Selling Covered Calls In an IRA
The main advantages of selling covered calls in an IRA include the following:
- You can keep the premium received from the sale as income. Most investors engaged in selling covered calls in their IRA do it for this purpose. The goal here is to improve annual returns by a few more percentage points. Thus, they sell covered calls quarterly or monthly.
- You’re allowed to sell the underlying stock at a price higher than the current price. Even if the underlying stock price has not reached your strike price, it can help you receive more money on the sale overall if the call is assigned.
- You can make money on non-volatile stocks in your IRA while holding them long term. Non-volatile stocks may only move 10-30% in 3-5 years. Selling covered calls on them allow you to collect up to 1% in premiums every month even when the stock prices are static or moving sideways. This way, you can earn money without selling the stocks completely and missing out on future growth.
Disadvantages of Selling Covered Calls In an IRA
Some of the downsides to selling covered calls include the following:
- You can lose money if the stock price falls below breakeven. The breakeven point on a position is the sum of the option premium subtracted from the purchase price. There’s the risk of the stock price falling beyond this point, which would amount to losing money on your position.
- You can miss out on large price rallies. You’re obligated to sell the stock at the strike price as long as your covered call is open. The premium you’ll receive provides some profit potential above the strike price, but the profit is limited. You have to sell as soon as the call is assigned.
- Selling covered calls may not protect your IRA in a bear market. Depending on your strike price, a bear market will still negatively impact your portfolio while selling covered calls. The options will expire worthless and you’ll only keep the premium. However, the premiums can’t offset the drawdown in a typical bear market.
Can You Use Covered Calls In Trustee and Custodial IRA?
You can’t use covered calls (or any other options strategy) on a trustee IRA. Only trustees have the authority to handle account investments in a trustee account.
You can only make investment decisions (including using the covered calls strategy) on a custodial or self-directed account.
You can trade options in a custodial account if your bank or broker has permitted options trading.
The approval process will vary from one broker to another, but it will typically involve reading and signing a disclosure form.
Talk to your bank or broker for a clearer idea of what works here and what doesn’t. You should also discuss with your financial advisor before you decide to incorporate covered calls into your investment strategy.
You can sell covered calls in an IRA once you get the required permissions from your bank or broker. Selling covered calls allow you to generate income on stocks you already own in a neutral or bullish market.
However, you should only consider selling covered calls if you’re willing to sell the stock when the call is assigned. You also have to be willing to accept losses if the stock price falls below the breakeven point and the possibility of missing out on more returns in the event of a rally.