IRA investors who have round lots of individual stock in their accounts have a way at their disposal to increase the return on their equity holdings that does not require additional contributions. They can use an option trading strategy known as covered call writing to generate periodic income from their stock holdings that can dramatically increase the overall return on their portfolios.

Covered call writing is the only kind of option trading that is allowed inside Traditional and Roth IRAs. Options are a kind of security known as a “derivative”. This is because their entire value is derived intrinsically from the value of the underlying stock. All types of options are always based on round lots of 100 shares of stock. For any given call option, there is always a buyer and a seller. The buyer of a call option is always bullish on the stock; he or she believes that the price of the stock will rise. The seller is always either bearish or neutral; he or she does not believe that the stock price will rise. The buyer will therefore pay the seller a nonrefundable premium in return for the right, or the option, to buy the stock at a preset price for a given period of time, such as 90 days. If the stock price rises, then the buyer can purchase the stock at the lower preset price from the seller and then sell it at a profit in the open market. But if the stock price falls, then the seller gets to keep the premium free and clear. This, of course, is the objective for the seller, or writer. When the stock price rises and the seller must sell the stock to the buyer at the preset “strike” price, then the seller must either buy the stock on the open market at its current higher price, or else deliver shares of stock that he or she already owns in order to cover the call.

This latter strategy describes covered call writing, where the call writer is “covered” because the calls are written against the stock in the account. For example, if an IRA investor has 500 shares of stock that is trading at $40, and he or she does not believe that the stock will rise in price anytime soon then the smart move would be to write 5 covered calls at a strike price of, say, $42 a share. Assume that the buyer must pay a premium of $150 for each call, giving the seller $750 of premium. If the stock price does not rise, then the seller keeps the $750. If the stock price rises above $42, then the seller will either have to deliver his or her 500 shares of stock to the buyer at $42, even if the price has gone to $50 in the open market. But historically, call writers get to keep their premiums about 80% of the time, and only have their stock called about 20% of the time. Of course, having the stock called in a retail account may have unpleasant tax ramifications, but this is not an issue in a IRA. And while you will inevitably get called out once in a while, you will still receive the strike price for your shares, so you can buy right back in.

Mathematically it is easy to see why this strategy could be profitable. If you were to receive the premium in the example above 9 months out of the year, then that would be an additional $9,250 of tax-free income for the year. The numbers in this example are probably slightly higher than what you may actually realize, but the concept is clear. If you would like to try covered call writing but are unsure whether you could do this yourself, find a stockbroker that specializes in this strategy and open an account. Good luck!