Retirement investors looking to boost income have an opportunity that probably doesn’t come to mind right away – trading in the options market with strategies like writing covered calls.
It sounds like blasphemy. After all, the standard advice is to play it pretty safe in retirement accounts like IRAs, and options would seem to violate all that. For every winning options bet, someone loses – likely the player with less experience. Most options contracts expire worthless, and since they have a fixed expiration date you can’t just wait for things to turn around like with stocks and bonds.
But don’t write off options in IRAs too soon. After all, many small investors have more money in their retirement accounts than in taxable accounts, so if options appeal to them, the IRAs are where the money is.
“Yes, you can trade options in IRAs,” says Mike Scanlin, CEO of Born To Sell, an online service for covered-call traders. “Covered calls are by far the most common strategy.”
Scanlin’s customers are typically between 40 and 70 and try to use covered calls to earn 1 to 2 percent a month on the securities involved, he says.
“Covered calls can also be a great way to get a little extra yield from an asset that might be declining but that you feel confident holding on to for the longer term,” says Russ Robertson, owner of ATI Wealth Partners in Atlanta.
“It’s not very common for individual investors to trade options within an IRA,” Robertson says, though he trades options for his clients’ retirement accounts. “Most investors take a long-term view of IRA assets, a view which we support, and don’t actively trade [in their IRAs]. Options inside an IRA are best suited to a disciplined, active investor that can monitor positions regularly.”
Writing covered calls can boost your gains with little risk. And by doing this in a retirement account you can avoid the tax expense and record keeping hassles that could be a real headache in a taxable account. “You just pay taxes when you take the money out of the IRA,” Scanlin says.
Firms that provide IRAs and rollover IRAs (for money transferred from 401(k)s and similar accounts) don’t generally promote options trading, but many do allow it. It’s less common to find options trading in a 401(k) unless it’s set up for very sophisticated investors, though many Solo 401(k)s, used by sole proprietors, do allow covered call writing.
Options trading rights in an IRA generally must be set up by filling out a form and acknowledging the risks. And these accounts typically do not allow trading on margin, or with borrowed money, a common feature in taxable options accounts. Typically, the IRA participant holder can write covered calls and buy calls and puts.
Options give the owner the right to buy (call) or sell (put) shares at a set price for a given period. The option purchaser pays a premium that is typically a fraction of the cost of the shares themselves, and profits if the security moves in the desired direction before the contract expires.
The person on the other side of the contract is the “writer,” so the writer of a call agrees to sell the shares at the contract price if the buyer chooses to exercise before the expiration date. The call is “covered” if the writer already owns the shares and will not have to buy them to complete the deal if the option is exercised. Either way, the writer keeps the premium – plus payment at the strike price if the call is exercised.
The cost of the premium varies. A contract with a long time to expiration – six or nine months, for instance, carries a higher premium than one expiring soon, and one with a strike price below the current market price costs more than one with a strike above the market. The stock’s volatility and market expectations about the share price also affect the premium.
For example, on Sept. 14, Apple (ticker: AAPL) was trading at $225. The seller of a call expiring Sept. 28 with a strike price of $230 could earn a premium of $2.73 per share, or $273 for a 100-share contract, boosting income by a little over 1 percent in two weeks.
It sounds like easy money, but experts say investors should consider several issues before writing covered calls:
Are options available? Options are available for most big-name stocks and many lesser-known ones as well. Options trades can also be done with shares of exchange-traded funds and many real estate investment trusts, but not with ordinary mutual funds. So the first question is do you own securities on which options are available?
Do you own enough? A single option contract involves 100 shares.
Investors who have loaded up on index mutual funds can get access to options by switching to exchange-traded funds tracking the same index. In a retirement account this exchange can be done with no tax bill.
Are you willing to sell? Once your covered call is sold you are obligated to sell the securities if the buyer exercises. It’s important, therefore, to set a strike price at an acceptable level, realizing you will miss out on any gains above that price. Writing covered calls is best for the investor who wants to sell all or part of a holding, or who believes the price will not rise above the strike price.
“The big risk with a covered call strategy is that you miss out on potential gains – something that has been particularly painful with tech names in the last couple years,” Robertson says.
Plan the next step. It’s best to have a plan for the proceeds if the option is exercised. Do you have your eye on another security? Will you keep the proceeds as cash for retirement expenses? Will you wait for the price to drop and buy the security again?
Robert R. Johnson, finance professor at Heider College of Business at Creighton University in Omaha, Nebraska, says covered calls can benefit retirees who want extra income on assets they are planning to sell anyway.
“Essentially, a covered-call writer is selling some upside potential in exchange for additional current income,” Johnson says. “This is particularly useful for IRA investors who are in retirement and are taking distributions from retirement accounts.”
Time and skill needed. Options trades take the same evaluation you would do for any stock or ETF. But while a stock has a single market price at any moment, every optionable security has many available options contracts with different combinations of strike price and expiration date. Writing a covered call expiring in a few days is obviously safer than one good for months, as much more can go wrong over a long period.
So, are you committed enough to do lots of study before and after writing a call? Robertson says that many retirement investors are not used to this much work.
“If an IRA is something you look at once a quarter when your provider sends you a statement, you should probably stay away from options,” Robertson says.