One of the indirect results of the Covid-19 pandemic is that it has caused millions of individual investors to fall in back in love with the stock market and fostered a newfound passion for option trading.
Options are financial derivatives, which means that they gain their value from the underlying security or stock. Options give the buyer the right, but not the obligation, to buy or sell the underlying stock at a predetermined price. The main difference between stocks and options is that stocks give you a small piece of ownership in a company, whereas options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date. Key Points
- Option Trading has become increasingly popular
- Using retirement funds is a tax-advantaged way to invest
- There is no UBTI tax when trading options
Two Types of Options: Calls and Puts
When one buys a call option, one has the right, but not the obligation, to purchase a stock at a set price, called the strike price, any time before the option expires. When the strike price of a call option is above the current price of the stock, the call is not profitable and is called out-of-the money. In other words, an investor is not going to buy a stock at a higher price (the strike) than the current market price of the stock.
When one buys a put option, one has the right, but not the obligation, to sell a stock at the strike price any time before the expiration date. Put options are considered out-of-the-money when the strike price is below the stock price since an investor wouldn’t sell the stock at a lower price (the strike) than in the market. Put options are in-the-money when the strike price is above the stock price since investors can sell the stock at the higher (strike) price than the market price of the underlying security.
In contrast, one can writes a call option, one may be obligated to sell shares at the strike price any time before the expiration date. Whereas, if one writes a put option, one may be obligated to buy shares at the strike price any time before the expiration date.
How Does Option Economics Work?
The buyer of an option can never lose more than the initial premium paid for the contract, no matter what happens to the underlying security. Thus, the risk to the buyer is never more than the amount paid for the option. Whereas, the profit potential, on the other hand, is theoretically unlimited as the stock price can go up without limit.
On the other hand, the seller of an option would receive a premium from the buyer. The seller of an option assumes the risk of having to deliver (if a call option) or taking delivery (if a put option) of the shares of the stock. In such a case, the seller’s loss can be unlimited, meaning the seller can lose much more than the original premium received.
All stock options expire on a certain date, called the expiration date.
The Pandemic Effect on Options
With the advent of no-commission trading platforms such as Robinhood, many individuals stuck at home during COVID-19 and flush with extra savings because of government stimulus and lock-downs have been turning to the equity markets as a source of income and fun. In order to supercharge one’s investment returns, many investors have been turning to option trading.
For example, by buying far “out of the money” call options on a security giving them the right but not the obligation to buy a security at a price well above its current value, an investor is able to profit on a surge of a stock price. Option trading has been seen by many as a catalyst for the January 2021 run-up in the stock price of GameStop and AMC. Investors have been going on Reddit’s Wall Street Bets forum to discuss strategy and joining together to jump into a particular stock, riding the stock price surge or slide together.
The GameStop rally highlighted a strategy in which small investors have aggressively bought calls of companies that have been heavily shorted by hedge funds and other large investors, forcing them to sell their positions as the price of the stock increases.
The popularity of option trading for many investors is that many don’t have the money to buy a lot of the stocks. When investing in options, you can buy them for a fraction of the price, and if you have options that move the same percent as the underlying stock, you can make money as if you owned the stock.
Option Trading & Your Self-Directed IRA
The Internal Revenue Code (“IRC”) only limits retirement accounts from investing in three types of investments: (i) collectibles, such as art, (ii) life insurance, and (iii) and prohibited transaction outlined under IRC 4975, which generally cover any investment that directly or indirectly involves or benefits a ”disqualified person.” The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the retirement account holder, any ancestors or lineal descendants of the retirement account holder, and entities in which the retirement account holder holds a controlling equity or management interest. Hence, one is permitted to invest in option trading with a Self-Directed IRA or Solo 401(k) plan. The question is, does option trading the trigger a tax known as the unrelated business taxable income tax, also known as UBTI or UBIT.
The UBTI tax is triggered in three circumstances:
- Retirement account uses margin to buy stock
- Retirement account invests in an active business through a passthrough entity, such as an LLC, or
- An IRA uses a nonrecourse loan (real estate acquisition financing) to purchase real estate.
In addition, IRC Section 512(b)(5) excludes from UBTI all gains, or losses recognized, in connection with an organization’s investment activities, from the lapse or termination of options to buy or sell securities (as defined in section 1236(c). Therefore, option trading is not defined as margin trading for purposes of IRC Section 512, and may be done in a retirement account without triggering the UBTI tax, which can go as high as 37%.
According to recent reports, average daily call volumes over the past three months have hit a new peak, with the bulk of the increase driven by “very small” contract sizes. Option trading can be lucrative but is also can be quite risky. Hence, before using a Self-Directed IRA or Solo 401(k) plan to engage in option trading, do your research and make sure you fully understand the risks involved. The good news is that if you decide to use your retirement funds to engage in option trading, you won’t have to worry about the UBTI tax.