Options Trading in a 401(k) or Other Accounts with Restrictions

Online Trading Academy Article of the Week

by Russ Allen, Online Trading Academy Instructor

Many people have some or all of their investing and trading funds in a tax-advantaged account, like an Individual Retirement Account or 401(k) in the United States; or in Canada, a Registered Retirement Savings Plan of a Tax-Free Savings Account.

How an investor should decide on allocation of funds between these accounts and fully taxable accounts is beyond our scope here. The point of this article is to discuss opportunities for option trading in such accounts, assuming an investor has some money in one of them and is interested in option trading to begin with.

The reason the issue exists is because all accounts of this type have restrictions on the type of investments that are allowed within them. For some, but not all, option strategies may be allowed in the tax-advantaged account that you have.

A typical set of restrictions for a tax-advantaged account might be as follows

Allowed:

• Covered Calls
• Protective Puts
• Long Calls
• Long Puts
• Cash-secured short puts (Some U.S. accounts)
• Debit spreads (Some U.S. accounts)
• Credit spreads (Some U.S. accounts)

Not Allowed:

• Short stock
• Naked short puts
• Naked short calls
• Cash-secured short puts (Canada)
• Debit spreads (Canada)
• Credit spreads (Canada)

There are ways to structure trades in these accounts however, that allow us to, in effect, make some of the kinds of trades that are not specifically provided for. The investor can then make his or her choice from a wider selection of strategies.

The key to doing this is awareness of the equivalence between different option positions. If we are not allowed to make a short put trade, for example, then we can construct an equivalent to that short put using elements that are allowed. If we are not allowed to do a long call and a short call simultaneously (debit or credit spread), then we can create equivalents for those too.

Here is an example.

On September 3, 2015, the daily chart of GLD, the exchange-traded fund that tracks the price of gold, looked like this:

GLD was at a demand zone around $107. With interest rate rises probable in the near future and other factors, there was a pretty good bullish case for gold. Option premiums were not high. This was an opportunity for a limited-risk bullish trade called a Bull Call Spread. This would consist of a long call at the $107 strike as the moneymaker; and a short call at the $112 strike to reduce cost and volatility exposure.

At that time, the $107 September calls could be bought for $1.89, and the $112 calls could be sold for $.33. Net debit on the trade would be $1.89 – .33 = $1.56. This would be our maximum loss, which would occur if GLD were to be below $107 at expiration. Maximum profit would be the $5.00 difference between the strikes ($112 – 107), less the $1.56 cost, or $3.44.

Here is the P/L graph of that trade with maximum profit and maximum loss shown in the table at the bottom of the chart:

Assuming that one was interested in this trade, there is a problem if we want to do it in a tax-advantaged account. The Bull Call Spread is a debit spread which might not be one of the permitted position types.

However, using the equivalency principle we can construct it in a different way that is allowable. Here’s how.

If we want to sell the $112 call in our tax-advantaged account we must also own the stock. The short call is then a covered call which is allowed.

And here is where the equivalency comes in: a long stock position with a protective put at strike price x is equivalent to a simple long call position with strike price x. “Equivalent to” means that no matter what the stock price might be at expiration, both positions (the protected stock and the long call) would make or lose the same amount of money. And usually in tax-advantaged accounts, buying protective put options to accompany a long stock position is an allowed combination.

In this case, we could buy GLD at its current price of $107.73 and simultaneously buy the September $107 put, which was then available for $1.16. If in the worst case GLD then finished below $107 at expiration, we would lose $.73 per share on the stock, but no more than that since the put gives us the option to sell it at $107 no matter what.

We also have to add in the $1.16 cost of the put itself. This, together with the $.73 maximum loss on the stock, gives us a worst-case loss for the protected stock position of $1.16 + .73 = $1.89. This amount may be familiar – it was the same amount as the cost of the $107 call mentioned above.

So we could use the stock + $107 put in place of the long $107 call that we used in the Bull Call Spread. Then, we can sell the $112 call for the same $.33 as before. This is allowed, since we also own the stock – the short $112 call is covered. The combined position is a $112 covered call with a $107 protective put also known as a collar. The $.33 that the short call brings in reduces our maximum loss to $1.89 – .33 = $1.56. This amount is exactly the same as the maximum loss on the Bull Call Spread. The position also has the same maximum profit of $3.44 with GLD at or above $112. In fact, our profit or loss at any stock price is exactly the same – the collar (which is allowed) and the bull call spread (which is not allowed) are in fact the same trade.

Using option equivalency we can construct in our tax-advantaged accounts most kinds of debit and credit spreads, opening up unlimited possibilities.

That’s all we have space for today. Let us help you to become an educated option trader, explore the possibilities.

Option Equivalents – Six of One, Half a Dozen of the Other

In the section above, we pointed out how equivalent positions can be used to construct an options spread trade in an account where spreads were not allowed. We used long stock, a long put and a covered call (all of which were available in that account) to create the equivalent of a bull call spread, which is not allowed. The point was to get access to something not formally offered in that type of account, in a way that is completely aboveboard and doesn’t violate any rules.

We saw there that owning a stock and buying a put option was equivalent to just buying a call option (with no stock). In fact, the stock-plus-put position could be called a synthetic long call.

Our approach there was a special case of a general rule about options, which is that equivalent positions, also called synthetic positions, can be created for any component of a stock or option position.

This is the basic equation: Cx = S + Px

Where Cx = the profit or loss on a call with strike price X

S = profit or loss on a Stock position

Px = profit or loss on a Put at strike price X

From last week’s example, the Cx we needed to create was the GLD call at the 107 strike price.

We synthesized it with 100 shares of stock, plus one put at the 107 strike. We showed that no matter where the price of GLD went, the stock-plus-put position would make or lose the same amount of money as the long call position.

We then added a short call at the 112 strike to give us an equivalent of a 107/112 Bull Call Spread.

Long calls are not the only things that can be synthesized. Rearranging the basic equation gives us these results:

Using these equivalents, we can create many kinds of option positions using combinations of the few basic ones we may be allowed. Here are some examples:

Note that both variations of the call spread above use the same components to make up the synthetic. What makes the position bullish or bearish is the selection of strikes X and Y. For a bull call spread we would usually select strikes X and Y so that X < stock price < Y. For a bear call spread it would be stock price < Y < X.

Again, both variations of the put spread use the same components and are differentiated by the strike prices. In both of the put spreads, we synthesize a short put at strike X using a lot (100 shares) of stock together with a short call at strike X. The short call is covered, since we own the stock, so it is allowed. The “extra” long put, at strike Y, is also allowed.

Options are like Lego blocks that we can assemble into different subassemblies for different purposes. Whenever there is a difficulty in buying or selling an option for some reason, we should always check for a synthetic solution. In many cases they are available and can allow us to do the trade that we want.

All of this assumes that we know what kinds of option positions we want in the first place. That takes training and education, like that provided in our Professional Option Trader course. Start building your foundation today.