Can you trade options in a roth ira account

Trading Options in Roth IRAs (SCHW)

Roth individual retirement accounts (IRAs) have become extremely popular over the past several years. By paying taxes on contributions now, investors can avoid paying taxes on capital gains in the future when taxes are likely to be higher. Roth IRAs must still follow many of the same rules as traditional IRAs, however, including restrictions on withdrawals and limitations on types of securities and trading strategies. In this article, we’ll take a look at the use of options in Roth IRAs and some important considerations for investors to keep in mind.

Why Use Options?

The first question that investors might be asking themselves is why would anyone want to use options in a retirement account? Unlike stocks, options can lose their entire value if the underlying stock price doesn’t reach the strike price. These dynamics make them significantly riskier than traditional stocks, bonds, or funds that typically appear in Roth IRA retirement accounts. (For more, see: Options Basics: Introduction .)

While it’s true that options can be a risky investment, there are many instances where they might be appropriate for a retirement account. Put options can be used to hedge a long stock position against short-term risks by locking in the right to sell at a certain price, while covered call option strategies can be used to generate income if an investor doesn’t mind selling their stock.

For example, suppose that a retirement investor holds a long portfolio consisting of low-cost Standard & Poor's 500 index funds. The investor may believe that the economy is due for a correction, but might be hesitant to sell everything and move into cash. A better alternative might be to hedge the S&P 500 exposure with put options, which provide him or her with a guaranteed price floor over a given period of time. (For more, see: Option Volatility: Introduction .)

Roth Restrictions.

Many of the riskier strategies associated with options aren’t permitted in Roth IRAs. After all, retirement accounts are designed to help individuals save for retirement rather than become a tax shelter for risky speculation. Investors should be aware of these restrictions in order to avoid running into any problems that could have potentially costly consequences.

Internal Revenue Service (IRS) Publication 590 contains a number of these prohibited transactions for Roth IRAs. The most important of them indicates that funds or assets in a Roth IRA may not be used as security for a loan. Since it uses account funds or assets as collateral by definition, margin trading is usually not permitted in Roth IRAs in order to comply with the IRS’ tax rules and avoid any penalties. (For more, see: Roth IRAs: Investing and Trading Do’s and Don’ts .)

Roth IRAs also have contribution limits that may prevent the depositing of funds to make up for a margin call, which places further restrictions on the use of margin in these retirement accounts. These contribution limits change each year. The limits for 2015 are $5,500 or $6,500 for those 50 or older. These do not apply to rollover contributions or qualified reservist repayments.

Interpreting the Rules.

These IRS rules imply that many different strategies are off limits. For instance, call front spreads, VIX calendar spreads, and short combos are not eligible trades in Roth IRAs because they all involve the use of margin. Retirement investors would be wise to avoid these strategies even if they were permitted, in any case, since they are clearly geared toward speculation rather than saving. (For more, see: Common Risks that Can Ruin Your Retirement .)

Different brokers have different regulations when it comes to what options trades are permitted in a Roth IRA. Fidelity Investments permits the trading of vertical spreads in Roth IRA accounts while Charles Schwab Corp. (SCHW) does not. The brokers permitting some of these strategies have restricted margin accounts whereby some trades that traditionally require margin are permitted on a very limited basis.

The use of these strategies is also dependent on separate approvals for certain types of options trades, depending on their complexity, which means that some strategies may be off-limits to an investor regardless. Many of these applications require that traders have knowledge and experience as a pre-requisite to trading options in order to reduce the likelihood of excessive risk taking. (For more, see: How do the Investment Risks Differ Between Options and Futures? )

The Bottom Line.

While Roth IRAs aren’t usually designed for active trading, experienced investors can use stock options to hedge portfolios against loss or generate extra income. These strategies can help improve long-term risk-adjusted returns, while reducing portfolio churn.

In the end, most investors should avoid the use of options in Roth IRA retirement accounts with the exception of experienced investors looking to hedge risks. Options should rarely be used as a speculative tool in these accounts in order to avoid potential problems with the IRS’ rules and taking on excessive risks for funds slated to finance retirement. (For more, see: The Most Common Roth IRA Investments .)

How to Add Options Trading to Your Account.

There's a lot to learn when it comes to trading options, but we have the tools to help give you the confidence to put together a strategy. When you're ready to start, you can add options trading to your accounts.

What are options and why would I want to trade them?

An option is a contract between a buyer and a seller. When you buy an option, you have a contract that gives you the right (not the obligation) to purchase or sell an underlying security, such as a stock, at a set price within a specific time frame. When you sell an option, you are obligated to buy or sell the underlying security if the buyer exercises his or her option. If the option isn't exercised or assigned by the expiration date, the contract expires.

While options can offer diversification in your portfolio, they’re not appropriate for every customer as they can carry substantial risk. Visit our Learning Center to find several courses on options trading. You may want to start with our introduction to options video.

What do I need to know?

There are different ways to trade options, resulting in various types of options strategies. Each strategy bears different risks and has a range of approval levels. Before you place your order, you'll need to complete an options application, have an options agreement on file, and be approved for the appropriate option level for the strategy you wish to trade.

Note: If you want to trade option spreads in an approved IRA, you'll also need to complete the Supplemental Options Spread Agreement (PDF).

The options application asks for a snapshot of your current financial situation so be ready to provide your:

Yearly income Options trading experience Net worth and liquid net worth.

If you prefer, you can download, print, and complete the Options Application (PDF) and, if requesting the ability to trade spreads in an IRA, the Supplemental Options Spread Agreement and send to:

Cincinnati, OH 45277-0002.

What to expect.

We'll let you know which option level you're approved to trade—either by in 1 to 2 days or by U. S. Mail in 3 to 5 days—based on your delivery preferences. Or call us after 48 hours at 800-343-3548, and we can provide you with your approval information.

Note: You'll need sufficient cash or margin buying power in your account before placing an order.

Frequently asked questions.

Options trading strategies involve varying degrees of risk and complexity. Not all strategies are suitable for all investors. There are five levels of options trading approval, and the approval requirements are greater for each additional level since there's more risk for you and Fidelity. Your financial situation, trading experience, and investment objectives are taken into consideration for approval. If requesting option Level 3 or higher, you’ll also need to apply for margin on your account.

The option trades allowed for each of the five options trading levels:

Level 1 is a covered call writing of equity options. Level 2* includes Level 1, plus purchases of calls and puts (equity, index, currency and interest rate index), writing of cash covered puts, and purchases of straddles or combinations (equity, index, currency and interest rate index). Note that customers who are approved to trade option spreads in retirement accounts are considered approved for Level 2. Level 3 includes Levels 1 and 2, plus equity spreads and covered put writing. Level 4 includes Levels 1, 2, and 3, plus uncovered (naked) writing of equity options and uncovered writing of straddles or combinations on equities. Level 5 includes Levels 1, 2, 3, and 4, plus uncovered writing of index options, uncovered writing of straddles or combinations on indexes, and index spreads.

An Options Agreement is part of the Options Application. When you complete the Options Application, you also confirm that you’ve read, understood, and accepted the terms of the Options Agreement. After you log in to Fidelity, on the Margin and Options Log In Required page, select Add to complete the Options Application.

To trade options on margin, you need a Margin Agreement on file with Fidelity. After you log in to Fidelity, you can review the Margin and Options Log In Required page to see if you have an agreement. If you do not have a Margin Agreement, you must either add margin or use cash.

Multi-leg options are two or more option transactions, or "legs," bought and/or sold simultaneously in order to achieve a certain investment goal. Typically, multi-leg options are traded according to a particular multi-leg options trading strategy.

With a call option, the buyer has the right to buy shares of the underlying security at a specified price for a specified time period. With a put option, the buyer has the right to sell shares of the underlying security at a specified price for a specified period of time.

You can access Fidelity's Options Trading Agreement on the About Options Trading page in Fidelity's online Brokerage Handbook. Also, Fidelity offers comprehensive options educational material in the Learning Center, under Learn About Options and from the Chicago Board of Options Exchange (CBOE).

800-343-3548 800-343-3548 Chat with a representative Find an Investor Center.

Margin trading entails greater risk, including, but not limited to, risk of loss and incurrence of margin interest debt, and is not suitable for all investors. Please assess your financial circumstances and risk tolerance before trading on margin. Margin credit is extended by National Financial Services, Member NYSE, SIPC.

There are additional costs associated with option strategies that call for multiple purchases and sales of options, such as spreads, straddles, and collars, as compared with a single option trade.

Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Before trading options, please read Characteristics and Risks of Standardized Options. Supporting documentation for any claims, if applicable, will be furnished upon request.

Should you actively trade in a Roth IRA?

I’m relatively young and just getting into the investment world. I recently opened a Roth individual retirement account with hopes that in five years, I would use it as a down payment for a home. I’ll be in my late 20s then.

However, one of my friends informed me that according to my initial plans in managing my account, I would need a regular brokerage account. He also said excessive trading will get me penalized.

Are there penalties for excessive trading on a Roth IRA? If I opened a brokerage account, what are the taxes on my capital gains?

Roth IRA accounts have a “seasoning” rule, meaning the account has to have been in place for five years before you can take money out as a qualified distribution without paying a tax on the investment earnings withdrawn. Your current financial plan has a five-year horizon before you want to use money in the account for the down payment on a home, so that shouldn’t be an issue. The first-time homebuyer distribution is limited to $10,000.

It’s common for mutual funds to limit your trading in a fund, so you can’t actively trade mutual funds in your retirement account, or any account. An exchange-traded fund, or ETF, may exist that closely matches a mutual fund. An ETF can be traded frequently, even during the trading day, which isn’t possible in an open-end mutual fund.

I’m not aware of any penalties for excessive trading in a Roth IRA when that account is established as a brokerage account. Your Roth IRA brokerage account can’t be a margin account where you can borrow any funds from your broker to invest. That keeps you from day-trading the account, but you can still actively trade the account.

Any taxes due on the investment earnings you take out of the account prior to age 59½, in general, are taxed as ordinary income. Investment earnings taken as nonqualified distributions would not be taxed as capital gains.

Recognizing capital losses in a Roth IRA account is possible, but you can only do that when all the amounts in all of your Roth IRA accounts have been distributed to you and the total distributions are less than your unrecovered costs from the accounts.

The typical retail investor won’t be able to successfully trade a Roth IRA account and pick up a substantially higher return on the account than he or she would by investing the account, especially after considering the trading costs. Trying to swing for the fences in order to grow a few thousand dollars into a much larger balance over the next five years to finance the future down payment on a house isn’t a very realistic plan.

That said, if you want to contribute a few thousand dollars to a Roth IRA brokerage account and see how you do with actively managing the investments in the account, it’s a great way to learn about the stock market and investing.

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How to Trade Options With Your IRA Account.

Options are contracts that permit an investor to buy or sell stock or another security at a fixed strike price. Internal Revenue Service rules for individual retirement arrangements, or IRAs, don’t say anything specific about options. IRS rules, however, prohibit borrowing for IRA transactions, so you cannot engage in any options trade that require borrowing. Trading options can involve high risk, as options are good for only a limited time. If you can't exercise options to make a profit before they expire, you lose all of the money you invested. Consider consulting a financial adviser before pursuing this investment strategy.

Broker Requirements.

Before you can include options in an IRA, a broker must approve you for trading these investment instruments. Not all brokerage firms allow options trading with IRA accounts. You’ll need to open a self-directed IRA account with a broker that permits IRA options trading. “Self-directed” simply means that you make the investment decisions for the money in the IRA. Because trading options is risky, you may have to show you have some experience investing before being approved.

IRA Borrowing Prohibition.

Due to the IRS prohibition on borrowing with IRAs, some forms of options trading are not allowed. Selling naked calls or naked puts, which are contracts not secured by assets you own, are two actions that wouldn't be permitted with IRA funds. Breaking this rule can be very expensive: The IRS may disqualify the entire IRA, and all of the money in it would become fully taxable in the year the prohibited transaction occurred. You may have to pay penalties as well.

Calls and Puts in IRAs.

You can buy call and put options with an IRA. Calls confer the right to buy shares at a guaranteed strike price. If the price per share rises above the strike price, you purchase the shares by exercising the option and then sell them at the higher market price. Puts give you the right to sell shares at a guaranteed price. If the per-share price drops, you can buy the shares at market price and use the put option to sell at the higher strike price. These transactions don’t involve borrowing so do not conflict with the IRS rules governing IRAs.

Writing Options Using IRAs.

You can sell options contracts instead of buying them. This is called writing options, and two types are allowed with an IRA. In a covered call, you write a call option and buy shares of the stock so you have them on hand if the option is exercised. In a cash-secured put, you sell a put option and keep enough money in the IRA to buy the shares if the put option is exercised. With both covered calls and cash-secured puts, you own the asset you have to deliver when options are exercised. No borrowing is involved, and thus you haven't violated IRS rules for IRAs.

Options as Insurance.

You can use options to reduce the risk of other investments made with IRA money. Suppose you own 100 shares of Company XYZ stock that is trading at $50 per share. You aren’t ready to sell the stock, but you don’t want to risk taking a big loss if the share price takes a nosedive. You can buy a put option with a strike price near $50 per share. Essentially, the put option insures the $50 price at the cost of paying a premium.

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About the Author.

Based in Atlanta, Georgia, W D Adkins has been writing professionally since 2008. He writes about business, personal finance and careers. Adkins holds master's degrees in history and sociology from Georgia State University. He became a member of the Society of Professional Journalists in 2009.

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