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TIPS + LEAPS thought experiment
Old 06-10-2011, 01:59 AM   #1
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TIPS + LEAPS thought experiment

You may have heard of a portfolio proposed by Zvi Bodie (author of Worry Free Investing), combining TIPS with a 5-10% allocation to LEAPS to give produce returns that keep pace with inflation plus a possibility of gain when the stock market goes up with less risk of loss if it goes down. The idea has been discussed on several threads over at Bogleheads, including a link to a Monte Carlo simulation of the potential returns and volatility, but I've never seen a detailed description of exactly how one would set up and manage such a portfolio. All the information I have gleaned through my reading on the topic is that the specific LEAPS included in the portfolio are at-the-money calls.

I did some reading about options and have tried to think it out for myself, but I'm just not getting it. Could a TIPS fund be used or must one use the individual bonds? Should the TIPS be all one maturity, or laddered? What term to expiry should the LEAPS have? Hold the LEAPS to expiration and then exercise if appropriate, exercise as soon as (you hope) the market goes high enough to make exercise profitable, or don't exercise at all but seek to sell the LEAPS itself at a profit? There are just too many questions I don't know the answers to. I'm consumed with curiosity and my requests for more details at bogleheads have not elicited the desired information, so I'm asking here: has anyone here either seen a detailed description of how this would work, or figured it out for themselves?
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Old 06-10-2011, 06:43 AM   #2
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It's a common strategy in structured products. I think I've attached his paper.
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File Type: pdf SSRN-id260628.pdf (38.7 KB, 27 views)
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Old 06-10-2011, 07:05 AM   #3
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From what I read, the strategy uses the LEAPS to give you a 10x leverage to the stock market and has you place the other 90% in TIPS.

A few things I don't get about it.

In a flat market, with the current real yield of TIPS less than 2%, you are going to lose money because the TIP yield is not enough to cover the purchase price of the LEAP option and it will expire worthless. You get no dividends from it either.

The cost of a jan 2013 $130 call option on SPY is about $10.50 when the stock is trading at $129. To generate $10.50 with the TIPS, using a rate of 2% real, you would need to have $525 invested in them.

$525 in TIPS and $10.50 in LEAPS is more like a 98% TIPS, 2% LEAPS portfolio.

I really would like to see a worked example using today's rates on both TIPS and call options.
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Old 06-10-2011, 07:17 AM   #4
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Congratulations! You have just recreated the equity indexed annuity, or something very similar to it. Shall I tell you where to send my commission check?
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Old 06-10-2011, 07:31 AM   #5
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I have recently been toying around with a variant of something like the TIPS/LEAPS but using LEAP spreads instead. I can't find an attractive spread in SPY or VTI, but I have located a pretty decent spread in microsoft. You can buy the Jan 13 $20 calls and sell the Jan 13 $25 calls against them for a total cost of $2.80 at market (but if you try, I think you could get the spread for $2.75). The return if microsoft is $25 by Jan 2013 is 2.20/2.80 = 79%. The return in a flat market (microsoft $24 by Jan 2013) is 1.20/2.80 = 43%. The break even point is of course a decline in microsoft price to $22.80.

If I could locate similar spreads across 8 or 9 other companies then I would be pretty comfortable doing a TIPS / LEAP spread on this. A decent amount of work though.

One advantage is the gains would be long term capital gains because of the holding period of the spread.
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Old 06-10-2011, 10:25 AM   #6
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The 90:10 ratio is simply an example. You have to do some additional arithmetic given the prices available to see whether the strategy is appropriate at any specific time. It's not voodoo, but neither is it a panacea.
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Old 06-10-2011, 03:11 PM   #7
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Congratulations! You have just recreated the equity indexed annuity, or something very similar to it. Shall I tell you where to send my commission check?

Not exactly I thought EIAs bought zero coupon bonds equal to the floor interest rate (typically zero) and then used the remaining money to buy the equivalent of LEAPs? Part of the sales pitch to EIAs is you can't lose money with these products, which is only true if you ignore inflation.

I think EIA do bad during times of high inflation. Of course other times EIAs are bad are during low inflation, rising, falling, or flat stock markets
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Old 06-10-2011, 03:31 PM   #8
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Well I entered half of the microsoft spread today by buying 40 jan 2013 $20 calls at $4.95. Now I just need a tiny spike over the next couple of weeks to sell the other side of the spread, the jan 2013 $25 calls. I would *really* like to get $2.45 for them, giving me the chance of a 100% return if microsoft stays flat.

looking to do this for apple, cisco, intel, and maybe corning (GLW). they all fit my mold of cash + good earnings + low PE. they are getting soooo cheap now too.

sorry if got off topic. but this does *sort of* fit the leap part of the tips/leap strategy :-)
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Old 06-10-2011, 04:45 PM   #9
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Not exactly I thought EIAs bought zero coupon bonds equal to the floor interest rate (typically zero) and then used the remaining money to buy the equivalent of LEAPs? Part of the sales pitch to EIAs is you can't lose money with these products, which is only true if you ignore inflation.

I think EIA do bad during times of high inflation. Of course other times EIAs are bad are during low inflation, rising, falling, or flat stock markets
Actually, EIAs are a pile of whatever fixed income the insurer invests in with a derivatives package that is essentially a bull spread on a percentage ("participation rate") of the face amount of the annuity contract. Plus a fat commission, profit for the insurer, overhead expenses, etc.
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Old 06-10-2011, 08:57 PM   #10
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From what I read, the strategy uses the LEAPS to give you a 10x leverage to the stock market and has you place the other 90% in TIPS.

A few things I don't get about it.

In a flat market, with the current real yield of TIPS less than 2%, you are going to lose money because the TIP yield is not enough to cover the purchase price of the LEAP option and it will expire worthless. You get no dividends from it either.

The cost of a jan 2013 $130 call option on SPY is about $10.50 when the stock is trading at $129. To generate $10.50 with the TIPS, using a rate of 2% real, you would need to have $525 invested in them.

$525 in TIPS and $10.50 in LEAPS is more like a 98% TIPS, 2% LEAPS portfolio.

I really would like to see a worked example using today's rates on both TIPS and call options.
Looking at the nominal Treasury STRIPS market, a zero-coupon strip that matures at the end of January 2013 would sell for 99.46 and mature at 100 (YTM = 0.32%). Using your numbers, a Jan 2013 at-the-money call on SPY would cost about 8% of the strike price. If you purchase the strip for 99.46, you would have 0.54 to purchase the SPY call. So you would only be able to purchase 0.54 / 8 = 0.068 call. At maturity of the strip, you would get back your initial investment (100) plus 6.8% of the price return of SPY.

To increase your participation rate, you need to (1) purchase a longer-dated strip, (2) purchase an out-of-the-money call, or as you noted above, (3) purchase a vertical call spread, or a combination of these. Typically this is done by purchasing a longer-dated strip (5 or 10 years). The risk, of course, is that the calls expire worthless, in which case you have tied up your money for the term of the strip (e.g. 5 or 10 years) and received a 0% return.

From the above link, a 10-year strip yields about 3.2% and would cost about 73 per 100 face. This would leave you 27 to purchase calls. Assuming the same implied volatility as the call in your example (19.5%), a 10-year at-the-money call on SPY would cost about 24, so you could purchase 27 / 24 = 1.13 calls. At maturity, you would get your original investment back plus 1.13 times the increase in SPY.

To preserve the purchasing power of your principal, you would need to repeat the above with a stripped-TIPS, if you can find one. Alternatively, you could use a nominal strip and make an assumption about future inflation and redo the above with inflation-adjusted numbers which, of course, would leave you with a smaller participation rate.
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Old 06-11-2011, 05:03 AM   #11
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It is an intriguing idea. But is the use of the leap (in this case) really hedging?? or is it higher risk investing?

I suppose the TIPS are the hedging part.

While I understand the basic concept. I am not sure I completely understand all of the trade-offs.

Those options are a something or nothing, time-bound proposition. You win or lose by a certain time. But they provide a large amount of leverage for a smaller amount of money, however that money is at much greater risk.

Being an equity index owner provides access to dividends from the equity and there is no expiration to the holding period.


It seems that Bodie's paper proposes a model for the accumulation phase. Do you think this type of approach is appropriate for the withdrawal phase?

***

The consumer banking industry got into the act with indexed CDs. Although, they do not seem to be offered at too many banks.

JP Morgan offers a large number of ETNs.

http://www.jpmorgansp.com/products/catalogue/index.html
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Old 06-11-2011, 03:09 PM   #12
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It is an intriguing idea. But is the use of the leap (in this case) really hedging?? or is it higher risk investing?

It seems that Bodie's paper proposes a model for the accumulation phase. Do you think this type of approach is appropriate for the withdrawal phase?
The deferred month option is not a hedge in the traditional sense, but neither should it be viewed as higher-risk than equity ownership; both long calls and equity positions suffer with a deterioration in market prices but the call limits your losses with a serious downdraft. Timing is important in this strategy, not so much in the sense of "bottoms" and "tops" but rather when considering the prices you might have to pay (or relinquish) for an estimated return, given a certain performance in the market. It's not impossibly complicated to do the "what ifs", but it's not as clean an approach to investing as a 1:1 portfolio of equities and bonds, so you have to have some degree of interest in alternative approaches to investing to explore it. I don't think it matters whether you're in an accumulation or distribution phase, but you have to want equity exposure for Bodie's approach to be attractive.
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Old 06-11-2011, 03:44 PM   #13
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It's a common strategy in structured products. I think I've attached his paper.
Thanks whitefish. I'm going to need to read it a couple more times before the lightbulb comes on.
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Old 06-11-2011, 06:27 PM   #14
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From what I read, the strategy uses the LEAPS to give you a 10x leverage to the stock market and has you place the other 90% in TIPS.

A few things I don't get about it.

In a flat market, with the current real yield of TIPS less than 2%, you are going to lose money because the TIP yield is not enough to cover the purchase price of the LEAP option and it will expire worthless. You get no dividends from it either.

The cost of a jan 2013 $130 call option on SPY is about $10.50 when the stock is trading at $129. To generate $10.50 with the TIPS, using a rate of 2% real, you would need to have $525 invested in them.

$525 in TIPS and $10.50 in LEAPS is more like a 98% TIPS, 2% LEAPS portfolio.
A similar criticism was raised in one of the threads at bogleheads. What if the market goes down and the LEAPS expire worthless? What do you do thenó take 10% of your reduced portfolio and try again? A way to get around this would be to buy LEAPS only up to the amount of interest income generated by the TIPS. That way, you never eat into the face value of the TIPS (including the accumulated inflation adjustment). The article linked by whitefish doesn't specifically say so, but I'm assuming the TIPS would be held in an IRA for tax-efficiency reasons. I'm pretty sure that buying a LEAPS call is permitted in an IRA, but don't know if that would be tax-efficient. That is one potential problem right there. The contribution limits on IRAs are so low. Would it even be possible to accumulate enough money to retire on in an IRA over the course of a 35 or 40-year career (never mind ER)? Maybe it would be do-able in a 401k or other employer plan, if TIPS are available, which they aren't always.

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I really would like to see a worked example using today's rates on both TIPS and call options.
Me too. That, and some more information about ongoing management of the portfolio. Here's how I think it might work:
  1. Buy some TIPS. If I understand how option pricing works, the quote of $10.50 for the Jan 13 LEAPS means one contract would cost $1050. It would take $52500 in TIPS to generate that much interest in a year.
  2. Buy at-the-money LEAPS calls with the previous year's interest. Nothing I've read about this portfolio says what expiry date the LEAPS should have, but since it uses LEAPS and not ordinary options I'm going to assume they should have as long as possible until expiry, and I think they should be American-style, not European-style. Looking at the cboe delayed quotes, for SPY, the longest-term options listed are Dec 13. If I'm reading the chart right, these last sold at $11.85, so it would take close to $60K in TIPS to throw off enough income to buy the longest available LEAPS.
  3. If the underlying index goes up, exercise; if it goes down, the LEAPS will eventually expire worthless. I think the index would have to go up higher than the strike price to make this worthwhile. Unless exercising the LEAPS pays more than it cost to buy them (including transaction costs and the earnings that would have come from reinvesting last year's interest income in more TIPS), you're going backwards. I've never used it, but I'm assuming I can set the "watch" feature in my online brokerage website to notify me if the the index hits the trigger price. Investing strategies that require constant monitoring and tweaking are not for me.
  4. If the index went down for a full year, it might be a good idea to make the next purchase a LEAPs put instead of a call. There would still be unexpired calls from previous years to exercise in case of a strong rally, and the put would be profitable if the index continued to fall.
  5. Every year, buy another LEAPS contract with the previous year's TIPS interest, so at any time the portfolio would include up to three LEAPS contracts.
  6. Use the profits from the LEAPS to buy more TIPS, which throw off more interest, so you can buy more LEAPS....
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Old 06-11-2011, 07:40 PM   #15
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If you dig around in the archives, I described how to replicate an EIA in detail. That is pretty much what you are all talking about.
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Old 06-11-2011, 09:45 PM   #16
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If you dig around in the archives, I described how to replicate an EIA in detail. That is pretty much what you are all talking about.
I saw that thread the other day, it was linked to in a more recent posting. The EIA is similar to TIPS/LEAPS, but the EIA thread only describes how to do it once, and what has been puzzling me about the TIPS/LEAPS idea is how the portfolio would be managed over time. With an ordinary portfolio of mutual funds or ETFs, it's managed by means of rebalancing, tax-loss harvesting, etc, but ISTM LEAPS call for different procedures because unlike funds or ETFs, they are going to expire. I don't see how it would be possible to just "buy and hold" them. As close as I can imagine would be to buy European style LEAPS and at expiration collect the profit, if any. But at my current (partial) state of options understanding, I think American-style LEAPS would be better to use for this type of portfolio than European-style, because the index only has to rise above the trigger price any time before the expiration date to be profitable, not be at the desired price level on the expiration date as with a European option. Or maybe there is some completely different method of managing such a portfolio that I am just not seeing??
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Old 06-11-2011, 10:23 PM   #17
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I saw that thread the other day, it was linked to in a more recent posting. The EIA is similar to TIPS/LEAPS, but the EIA thread only describes how to do it once, and what has been puzzling me about the TIPS/LEAPS idea is how the portfolio would be managed over time. With an ordinary portfolio of mutual funds or ETFs, it's managed by means of rebalancing, tax-loss harvesting, etc, but ISTM LEAPS call for different procedures because unlike funds or ETFs, they are going to expire. I don't see how it would be possible to just "buy and hold" them. As close as I can imagine would be to buy European style LEAPS and at expiration collect the profit, if any. But at my current (partial) state of options understanding, I think American-style LEAPS would be better to use for this type of portfolio than European-style, because the index only has to rise above the trigger price any time before the expiration date to be profitable, not be at the desired price level on the expiration date as with a European option. Or maybe there is some completely different method of managing such a portfolio that I am just not seeing??
Uhhh, with an EIA structure you use the coupons to put on a bull spread for a portion of the notional amount of your investment. Every year you collect what your options have earned (if anything), rinse and repeat. That is how you manage it long term, essentially on autopilot.
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