A Reader Writes "Would you be so kind to explain this please?"
Hello Friends! Thanks so much for stopping by my blog, Stock Picks Bob's Advice. As always, please remember that I am an amateur investor so please consult with your professional investment advisor prior to making any decisions based on information on this website.

This evening, checking my email, I noted that I had a question regarding a rather complicated options strategy that our reader states he entered into after taking a "3-day class". Not being very knowledgeable on the fine points of options, I would like to encourage our readers to comment here on Josie's question, who wrote:

Hello Bob,



I own a NYSE stock, Graftech Internation LTD (GTI). Additionally, I really wanted to buy the call (.gtila) but my Scottrade IRA account would not allow me. It said that I can only “Sell to Open” my position – the complete opposite of what I wanted to do. Out of curiosity, I went ahead and did it. I bought 1 .gtila “Sell to open” call option at ask price of $1.15, $5 strike price, Dec 2005. Now what happens? Do I now “Buy to Close” my position? This whole thing confuses me. Would you be so kind as to explain this please? I took a 3-day investing class and made a lot of notes from the 3-day class, but this transaction has got me so confused.



Thanks so much,

Josie

I found some information on Investopedia.com regarding some of these issues that hopefully will help you sort it out:

Before trying to understand the different positions one can hold with options, think of the positions one can hold with stocks. With a stock you can either buy it or sell it. You have only two alternatives.

However, because of the nature of options, specifically their contractual basis, they offer four different alternatives for entering and exiting positions. There is an option writer and an option purchaser. The writer can enter or exit a transaction, and so can an option purchaser. Entering an options transaction as a writer is known as opening a short position - or selling to open. Conversely, when a writer closes a short position, he or she is buying to close. The person buying an options contract is said to be opening a long position - or buying to open. Finally, an options purchaser exiting or closing a long position is said to be selling to close.

In summary, a person holding a short position (contract writer) can sell to open (enter a contract) or buy to close (close a position). A person holding a long position (contract purchaser) can buy to open (enter a position) or sell to close (close a position).

O.K., I am not an option trader, but from what I can tell, you already own Graftech (GTI). The key to being unable to do certain transactions in your IRA account is they these may be prohibited in IRA's. However, the sale of call options on your existing positions is allowed. This transaction is called opening a short position or "selling to open". Now, when you want to close a short position, exiting from the contract that you wrote, you are "buying to close" which is what your Scottrade IRA account permitted.

The following is a discussion of some of the limits of option trading allowed in IRA's that I found on the SmartMoney website:

As far as we're concerned, your retirement account is no place to pursue such a risky investment strategy. But since it is your money, we have to tell you: You are allowed to buy options, both puts and calls, in an IRA.

Some IRA plans specifically disallow the trading of options. But even for those that do permit it, what you want to do is against the law. That's because you want to trade uncovered, or naked, options which entails investing money borrowed from a margin account. That is prohibited by the IRS, says John Power, a vice president at the Options Institute, the educational arm of the Chicago Board Options Exchange.

Let us explain for the uninitiated: When you buy put or call options from your broker, you are essentially buying the right to buy or sell a stock at a specific price on a specific date. Your liability is limited to the amount of money you've invested. Likewise, you can sell a call option when you own the underlying shares -- what's known as writing a covered call. In this case, the shares you already own are collateral for the option. But when you write an uncovered call, and hence do not own any of the underlying shares, your liability is potentially unlimited. That's because you may have to go buy the shares at the market price, but deliver them at the option's strike price.

Anyway, we recommend that almost all individual investors steer clear of trading options, except for highly specific hedging situations. Otherwise, it isn't worth the risk.

Again, I must emphasize that I am an amateur investor, so I am not an expert at the trading of equity options, let alone the specifics of trading within an IRA account. Clearly, since the trading of "naked" options contracts may entail unlimited risk, these are not allowed inside of accounts that are limited by law to contributions that are clearly delineated. I believe that this is why your account locked you out on that particular trade!

I hope this is helpful! And I hope that some of the professional investors who stop by this website on occasion will join in on this discussion. In any case, I would encourage you to consult with your professional investment advisors to get more information on this particular question!

If you have any other questions or comments, please feel free to email me at bobsadviceforstocks@lycos.com or leave them right here on the blog.

Bob