What is an IRA (Account)?
An IRA or an Individual Retirement Account is a special account type purposed for retirement savings. IRAs offer many different tax advantages over other account types, but they don’t necessarily work like other account types and they have many restrictions. There are a few different IRA account types, the most common ones are Traditional IRAs and Roth IRAs. (This is the case in the US, I am unsure how things are in other regions).
What is a Traditional IRA (Account) and What is a Roth IRA (Account)?
The only real difference between a Traditional and a Roth Individual Retirement Account is different Tax benefits for different situations.
In a Traditional IRA, you are allowed to deposit income without paying taxes on it. But all gains made with the deposited capital is liable to tax.
In a Roth IRA, on the other hand, you do pay taxes on the deposited income. But because you already paid taxes when depositing money, you won’t have to pay any taxes on any gains made with that money.
Basically, it is all about finding out in which account an individual will most likely have the biggest tax advantage. This can depend on many things, especially on things like your tax bracket while earning money and when retired.
Furthermore, there actually are different requirements for the different IRAs.
However, I don’t want to get too much into all the details about the different IRAs, their advantages, how they work and how you should use them. The question that I want to answer in this article is:
Can you Trade Options in an IRA (Account)? – IRA Options Trading
Options are an extremely versatile, flexible and just good derivative. They are a very good way of making money in the markets. This is a good thing for all accounts, including retirement accounts. But you can not trade options in a retirement account in the same way as you could in other accounts. There are restrictions. First of all, when opening an IRA, you have to request option trading approval and chose an IRA that supports option trading. Most IRAs allow you to trade options, but not without limitations. IRAs work similar to cash accounts. This means that you are not allowed to trade on margin. Without any margin, you can only trade certain option strategies. You can not trade any undefined risk strategies in Individual Retirement Accounts. Note that brokers have different option trading levels for their clients. This means that you can’t just open an account and begin to trade any option spread that you want to. These levels also do apply to IRAs. In the first level(s) you will probably only be allowed to trade long puts/calls and covered calls/cash secured puts. These strategies are all fairly low risk. But in higher option trading levels, you can trade more advanced spreads, like credit spreads, iron condors etc. You just will need to have a margin account for the last level with no restrictions. You can’t get to this level in an IRA, because you can’t trade on margin in an IRA.
(The option trading levels vary from broker to broker. Usually, there are between 3 and 5 different levels with different restrictions.)
But this does not mean that you can’t trade options in an IRA. Trading options in IRAs is definitely possible! You just can not trade any undefined risk strategies in an IRA. This should be fine for most option traders. Option sellers are the only ones that could have a little problem with this. But I can tell you that there are plenty of very good and profitable option strategies that have a limited downside. In fact, I would say that defined risk strategies probably are even better than undefined risk strategies, especially for beginners or people with smaller accounts. You can turn almost every undefined risk option strategy into a very similar defined risk strategy. Let me give you some examples
(To learn more about other trading strategies for IRAs, click here.)
How to trade Short Option Strategies in IRAs?
Let’s start with a very simple example:
A short Call is an undefined risk strategy that you could not trade in an IRA. But if we just add another long leg one or more strikes above the short strike, the payoff will change slightly. Now we just made us a defined risk strategy (Credit Spread) with the exact same payoff, except that it now has a limited downside. This is also doable with a short Put.
Now let us go a little more advanced. If we take a very common strategy like a Strangle and want to turn it into a defined risk trade, we just do exactly the same as we did before. We add another long leg at a higher/lower strike price. This time we have to do it on both sides though. As you clearly can see on the payoff diagrams below, we just created a Strangle with a limited downside (aka. Iron Condor). Again the payoff diagrams look very similar. The adjustment below can also be done on a Straddle. This will just lead to a relatively narrow Iron Condor. An Iron Condor is a defined risk strategy, which is allowed in IRAs.
These are examples of some of the most common, undefined risk short option strategies. Just always remember, if you want to turn an undefined risk strategy into a defined risk strategy, you mostly have to add one or more long legs at a higher or lower strike.
But bear in mind that this will lead to a decrease in premium. On the other hand, you will get a limited risk trade that is ‘tradeable’ in almost any account type. This is not necessarily only relevant for option traders with IRAs, this can be useful for beginner traders or traders with smaller accounts as well.
Note that details about option levels, option trading and IRAs can and will vary from broker to broker. Many brokers handle these things differently. I advise you to ask your broker directly about his requirements and allowances.
Additionally, I want to remind you that IRAs are meant for retirement savings. This is most likely money that you don’t want to lose, so don’t trade like this either. Educate yourself before risking any money. Education is extremely important when it comes to trading, especially for option trading. There are plenty of (free) educational (option) trading sites out there. Mine is one of them. If you want to learn more about my free education, you could visit this page.