How Options Can Enhance Your Nest Egg
Because options are generally used as trading instruments, you may get the idea that they aren’t really fit for retirement accounts. That’s not necessarily true.
The IRS bans borrowing in an Individual Retirement Account (IRA). That means you can’t short stocks. You’re limited in your trading choices to buying stocks and selling those that you already own, but in that regard, options can give you a new level of flexibility.
You can’t perform the riskiest of option-trading strategies, such as selling a naked call. But you still enjoy sufficient elbow room in an IRA with options, to the degree that they can boost your returns.
(Each broker has its own policy, so it’s best to check directly with your broker to see what it does and doesn’t allow.)
Here are two common strategies that can deliver extra income for your IRA. Both of them involve selling, or writing, an option.
Covered Calls For Extra Income
First, although you can’t sell a naked call in an IRA, selling a covered call is ok.
One option contract equals 100 shares of the underlying stock, so you must have at least 100 shares of the underlying stock to execute a covered call.
For example, let’s say you have 550 shares of the volatile stock Vipshop (NYSE: VIPS), a Chinese e-commerce firm. The maximum number of option contracts you can sell would be 5.
As of December 6, VIPS was trading at about $13.50. You could sell the May $17 calls for $0.65. This means your proceeds would be $65 per contract.
(Nowadays if you use a low-cost broker, the commission should be less than a dollar per contract, so to keep things simple I will ignore the commission.)
Like a Cash Dividend
If you think of the option premium like a dividend, this means you received $0.65 per share for locking up your VIPS shares for about six months. That’s the rough equivalent of a 9.6% dividend yield!
To calculate a dividend yield, you divide the annual dividend payment by the current stock price. Since the length of the call is about six months, you could theoretically do this trade twice in a year. That means the calculation is $0.65 x 2 / $13.50 = 9.6%.
And remember, you can write up to 5 contracts. Thus, you could collect up to $320 (after commission) in premium.
The best-case scenario would be if VIPS rises, but falls short of $17 by expiration date. The options expire worthless, you enjoy the price gain, and you are free to sell more covered calls.
If these calls are exercised, you have to sell 500 shares at $17, but you keep the premium and you’d still have 50 shares left over.
If VIPS is above $17 at expiration and it’s called away, if it is below $17.65, you still make a profit on this option trade.
Even if VIPS was above that breakeven price, the price gain between $13.50 and $17 ($3.50 per share, or $1,750 for 500 shares) still belongs to you. That’s a gain of about 26% not counting the premium you collected. Not shabby at all.
To reduce the chances of seller’s remorse, pick a strike price at which you would be happy to sell the stock anyway.
Now, if VIPS falls and you don’t want to hold the stock, you can buy to close the option position (likely at a profit) and then sell the stock.
Another Way to Make More Money
The second common strategy is to sell out-of-the-money (OTM) puts. This makes most sense if there’s a stock you like, but you want to buy it at a lower price. Selling OTM puts lets you collect the premium and buy the stock at a lower price if the option is exercised.
In an IRA, you will need to have the cash to cover the stock purchase in case the put is exercised. This is called a cash-secured put.
For example, if you sell two contracts of the General Electric (NYSE: GE) June $10 put, you will need to have $2,000 in cash in your account set aside as reserve.
As long as the option position is open, you can’t invest that $2,000 in another stock. However, you can buy money market funds with it to earn a little extra return.
It may seem like a nuisance to have $2,000 locked as reserve, but remember you collected a $130 premium (the GE June $10 put is trading for $0.65). That’s a 6.5% return against that $2,000!
Beware of the Downside
The danger in such a trade is that the GE share price could collapse. If GE suddenly fell to $7, the shares could be put to you at $10. You would be down $2.35 per share right off the bat ($3 minus the $0.65 premium).
The key is to find a find a stock that you like and to strike a balance between a low enough price that you would be happy to buy the stock and a high enough premium to make it worth your time.
If you see GE fall below $10 and you change your mind about the stock, you could buy to close your option position (likely at a loss). Or if you still like GE, just let the shares be put to you. It depends on your own preference.
Used properly, the premiums add up over time and provide an extra return boost for your retirement account.
Editor’s Note: Our colleague Scott Chan just described a proven way to enhance your nest egg.
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