Index Roll Investing Strategy: A Complicated Approach

The Index Roll is a passive long-term investment strategy that combines indexed investing with cheap investment debt using long-term call options (LEAP calls) to achieve very high investment returns.

The investment strategy is passive. It requires no trading, speculating, or ongoing financial analysis, and the investment gains are based upon the performance of well-known, industry standard indexes.

The Index Roll focuses on delivering high, long-term investing returns while tightly managing cash outflows. It is designed for an investor who wants to put away a certain amount of money every month in an investment fund for many years (i.e. saving for retirement) and isn't concerned about short-term volatility.

It is important to fully understand Rolled LEAP Call Options before using this strategy.

Portfolio Construction

The goal is to build a diversified portfolio. ETFs are diversified themselves, but a combination of ETFs provides even further diversification.

There are three indexes that are recommended: IWN, MDY, and EFA. Other potential indexes are discussed in the Indexes and ETFs page. Our choices are limited because LEAPs are only available on a small fraction of the ETFs available. Hopefully, access to ETFs through LEAPs will continue to expand.

Ticker Name Description
IWN Russell 2000 Value Fama-French Value Index
MDY S&P Midcap A few hundred US midsize companies
EFA MSCI Europe & Far East Largest companies in Europe & Asia

All of these ETFs have shown historically good performance - over 10% per year.

Portfolio Sizing

Sizing is tricky. A portfolio that's too large will expose the investor to short-term risk as the roll forward costs eat up their cashflow. A portfolio that's too small won't make a meaningful contribution to the investor's financial situation.

This means that portfolio size has a lot more to do with an investor's financial situation and personal preferences rather than anything else.

Still, some rules of thumb apply. An investment that appreciates 10% a year will gain between +160% to +210% over a 10 to 12 year holding period.

Growth Factors at 10% appreciation:
Years Growth
5y +61%
10y +159%
15y +318%
20y +573%
25y +983%

This means we can work backward - determine how much money we want in ten to twelve years and build of options that controls an ETF portfolio equal to half that amount.

Simple Example: Joe wants $1m in 10-12 years. He buys options on $500k of IWN, MDY, and EFA. The options have an initial purchase price of $80k. In 11.5 years, his portfolio is worth $1.5m and his options are worth $1m.

Of course if Joe doesn't have $80k to invest or if he can't cover the ongoing roll forward costs, then he shouldn't try to handle this portfolio.

Here are some other guidelines for sizing a portfolio: (Note that we're describing the underlying ETF portfolio, not the option portfolio. Option portfolios are much smaller.)

1. A portfolio of $100k or less is too small to make a meaningful difference unless its held for 25+ years.

2. An initial portfolio of $250k is appropriate for most high-income professionals. It has low purchase and roll forward costs and will turn into $500k in 12 years and $1m in 17 years. This is a good portfolio to use in combination with other investments, such as real estate or other active stock investments.

3. For an aggressive investor, a $400k to $700k portfolio will generate $1m in 9 to 13 years. It will have relatively high roll forward and purchasing costs and should be planned carefully.

Note that the above examples are simplified and don't take into account dollar cost averaging or roll ups, which is essential to reducing risk. Large stock purchases should always be made over a period of years.

For best results, continue to add to the portfolio by making small purchases indefinitely. As the share price will continue to grow, these purchases will likely be quite small - perhaps only 200-300 shares a year per ETF.

Roll Ups can be used to generate cash for additional investments. However, most roll-ups will happen at a market top rather than a market bottom, which can lead to overinvestment at poor prices. Instead, put the extra cash in a money market fund and continue to make regular investments on schedule.

Taxable and Retirement Accounts

There are many places to open an option account. One of our favorites is TradeKing. In order to trade options, you will need Level 2 option privileges, which will require filling out the appropriate forms.

Long-term call options that are held for more than a year get long-term capital gains tax treatment, i.e. 15% rates for most people.

Options can also be held in different types of retirement accounts, such as a Roth or IRA. An IRA can provide an immediate tax deduction, which is a great tax benefit. A Roth IRA doesn't provide an immediate tax benefit, but allows earnings to accumulate tax-free until retirement.

There are many different types of IRAs including SEP-IRAs, 401ks, etc, that all provide similar benefits.

Options can always be moved between accounts, including at Roll forward time. For example, sell an option on SPY that expires in 12/2007 in a taxable account, and buy an option on SPY in a retirement account that expires in 12/2008.

One important point to make: The Index Roll is not a trading strategy. Many people find buying and selling options fun and perhaps a little addictive, especially in a rising market where the gains seem to come easily. But every trade makes your broker and the options exchange a little richer, and you a little poorer. Our advice is to make a purchasing schedule that minimizes trading and then stick to it.

Step-by-Step Recap

1. Select a diversified portfolio based upon indexes. For example, one-third SPY, one-third MDY, and one-third EFA would be a good portfolio.

2. Determine how much wil be invested based upon future financial goals and capability to repay roll forward costs.

Example: If roll forward costs are about 3% of the total portfolio, and the investor can afford roll forward costs of $1000 a month or $12,000 a year, then a portfolio of $400,000 can be safely maintained. Do not over-estimate this number.

3. Open the options account and invest the pre-determined amount over a pre-determined schedule using Dollar Cost Averaging.

4. Select LEAPS that have a strike price 10 to 20% below market price for best results. For a retirement account, 20% is probably the best.

5. Hold the options for at least a year and then roll them forward by selling the original (which should have at least 9-12 months left on it) and buying a new option that expires later.

6. After a few years, if the index has appreciated by at least 25%, consider rolling up the strike price to generate income. Pick a strike price 20% higher. Don't do this too often, and don't immediately re-invest the cash.

7. Put aside roll-up cash and extra cash and use it to pay roll forward costs. Some of this cash can be re-invested in more index options, but please be conservative. Re-investing aggressively will result in buying at market tops. It's much better to make small purchases over time.

Questions and Answers

1) Why do the indexes return 10%? And why would someone loan you money for 4% to invest at 10%?

Index Returns
Index Returns are the product of many factors, including interest rates, earnings growth, stock valuations, and investor expectations. There's no exact answer for why they have returned 10% on average for the past 70 years.

The most likely explanation is that investors expect a risk premium for equities than from other investments, and that historically this premium has been about 4-5%, leading to corporate equity returns of about 9-10%.

Cheap Debt
The option market loans money cheaply because the seller benefits from the high premium on in-the-money options and can re-invest that money. That premium "buys down" the interest costs.

Also, owners of options don't get dividend payments. Indexes don't pay very much in the way of dividends, but they do pay a little, and the institution that sells an option takes the dividend into account when pricing it, which ends up lowering the effective interest rate.

2) Are you sure that the indexes will keep going up? What about oil prices, terrorism, the baby boomers, the trade deficit, bird flu, etc?

In our finance classes, our professor taught us that all investing starts with a view. A view is your belief about the future. You build an investment to match your view. Then, if your view is correct, you will make money.

The Index Roll strategy is based on the view that, over a period of several years, the rate of return of the selected indexes will be higher than the cost of holding options on those indexes using LEAPs. We have selected an investment, in this case long-term in-the-money call options on the indexes, to support this view.

Note than the view is not based on an absolute rate of return. If the index returns only 5% annually over a ten-year period, but the cost of owning the option is 4%, then the investment strategy will make money.

Historically, the indexes have returned roughly 9-10% a year, and the cost of owning and rolling a LEAP with a lower strike price is about 3 or 4%, which makes for a healthy margin. However, there have been many years in which the indexes have declined or have underperformed the cost of owning the option, which would result in a loss for those years.

That's why leveraged indexing is only recommended for long-term investors who have the income to pay the interest regardless of the short-term rises and falls in the value of their portfolio.

As to the health of the global economy, well, no one can predict the future. But keep in mind that you're investing in companies not countries. And companies sell to customers. So the long-term health of the index really depends upon whether you think people around the world will continue to buy the companie's products.

3) What about the internet bubble? The markets were terrible from 2000 on. Why would I want to borrow money to invest in those kinds of markets?

Throughout the 90s, the S&P 500 returned 14.9% annually, well above the 10% historical return. This set the conditions for a multi-year market correction that was brutal for most investors, whether they were invested in technology or not. However, any investors who bought before the boom or during the correction were well rewarded when the markets recovered.

Here's the recent investment returns for the S&P 500. (Jan 1 to Dec 31, CAGR.):

Years Return
1996 +22.6%
1997 +33.1%
1998 +28.7%
1999 +20.8%
2000 -9.3%
2001 -12.1%
2002 -22.2%
2003 +28.5%
2004 +10.7%
2005 +4.9%
2006 +15.7%

You can see some ugly returns in there, but some great ones too. What's it all add up to for the last ten years? About 8%. No, it's not quite 10%, but it's still well above the cost of holding an option.

The moral of the story: Stay invested for long periods, and continue buying when the markets fall. Many investors missed out on 2003's great returns because they were too shell-shocked from the preceding years, but anyone who was watching the market knew that earnings were rising and that the market was overdue for a good year.

And also, the above is just for the SPY. Things have been much better for the MDY (mid-cap). That index has returned 13.4% annually over the past ten years. The EFA has also performed very well. This also shows how important it is to diversify across indexes.

4) I know a great stock. Why shouldn't I choose that over the index?

The Roll can be used for stocks, not just options. Still, the carrying costs are much higher for most stocks, especially those with no dividends and high volatility.

For a stock like GM or Yahoo, the Roll Forward cost is very high and it would be very hard to get consistent long-term appreciation. Stocks like Bank of America or GE have low roll forward costs and would make good candidates for a Roll strategy.

But think of the Index Roll as a complement to an existing active portfolio. Most stock pickers invest in certain stypes of stocks and often go through periods of underperformance where they don't beat the indexes. Owning the index during those periods will provide more diversification, less volatility, and most likely higher returns over time.

5) What happens when I can't roll forward my LEAP?

Why can't you roll forward your option?

I'm broke.
We told you this would happen if you overinvested. An important part of this strategy is managing the future roll forward costs. Now you're in a bind.

Your best bet is to roll forward and then up to a higher strike price. You're giving up some of your long-term appreciation for some short-term gains, but that's just how it is.

Don't panic and let your options expire or liquidate your portfolio, especially if you've taken some losses. Otherwise you'll throw away all of your previous time and money.

I can't contribute any more to my retirement account.
Options can be rolled forward between accounts. Sell the option in the retirement account and buy it in a taxable account.

I can't get my exact strike price.
That's no big deal, just choose the closest, lowest strike price you can. That way you keep your investment position constant and your leverage about the same.

I don't see a two year option available, just shorter term options that expire in 18 months or so.
New LEAPs come out on a certain schedule, and usually in the summer but sometimes in the winter. You're probably a couple of months too early, so just sit tight.

We'll post the schedule when we find a good link.
They don't have strike prices that low on my ETF any more. Every strike price is higher.

Your ETF appreciated so much that you can't get a strike price that low anymore? That's a nice problem to have. You must have a lot of equity in that LEAP. Or maybe you're trying to roll over the EFA, which has limited strike prices.

Go ahead and roll up to the lowest strike price. Take the extra cash and put it in a savings account or relatively secure investment to pay future roll forward costs.

6) Don't you lose a lot of money on the bid-ask spread?

Some options have very low bid/ask spreads, and some have high ones. That has to be a factor in selecting options. However, since you're only rolling over your options once a year, you have to put it in perspective.

7) If you sell before expiry, don't you miss out on some of the appreciation?

Options are constantly being revalued by the market based upon the time left, the strike price, volatility, and interest rates. If you sell early, you're missing out on potential appreciation, but get the benefit of time value and somewhat reduced risk (because the option could go down before expiry).

8) We just had a correction and the market seems very volatile right now and option prices are very high. Are you sure I should buy or roll over an option right now?

Maybe not. Right after a major market decline, volatility can spike and make options a lot more expensive. In the long run, over years of rolling over an option, it won't have much of an impact, but it could reduce your first year's returns significantly. I would wait a day or two until the market settles down.

For rolling over, it doesn't make as much difference because you're selling an option at the same time you're buying another one, which mutes the effect of volatility. It's only the first option purchase that's really impacted.

9) The Index LEAP sounds like a much better deal than the Index ETF. Why would I ever own the ETF by itself? Or even invest in an index fund?

We're not going to call any index investor a chump. Vanguard's $100B Index Fund has beaten 90% of all other actively managed funds. On the other hand, yes, you can get much better capital efficiency by using a deep in the money LEAP call option and putting the balance in a money market account or even some other investment.

10) How do I diversify against this strategy?

Ha! That's funny. Diversifying against a massive leveraged portfolio. Oh, you're actually serious.

This is actually a very complex question. Diversification is dependent upon both portfolio size and relative allocations, and on each investment's individual volatility. A small, highly volatile investment may make more of a contribution to portfolio returns than a large diversified investment.

The indexes have relatively low volatility, and the volatility is even lower when two or three are combined. On the other hand, a $250,000 portfolio will have daily price swings of +/-$1,500 or so. Your other investments may have similar price volatility, or may be very stable.

Many people use the Index Roll as a complementary investment, providing diversification against their other active investments.

But even if the Index Roll dominates your investment portfolio, you can still be diversified within the Index Roll strategy by selecting a portfolio that's diversified by industry, country, company size, and time by using different index ETFs and purchasing them on a defined schedule.

11) I'm interested in income. Would this help me?

Using roll ups, this strategy can generate income. However the income is unpredictable.

For example if you hold options on IWN for ten years, its very likely you will get a lot of income sometime within that ten years.

If that sounds unclear, and you're wondering how to pay your rent during that time, well, that's the problem. Investment returns are unpredictable, so we don't know exactly how long it will be before you can comfortably do a roll-up.

We can do some calculations based upon average returns. Let's say that you buy ETFs with a strike price of 80% of market price, and hold them until the market price rises to 150% of strike price, or 120% of the original market.

Then, if your ETFs rise at 10% a year, you will be able to roll up your options in about two years and get 16% of the original market price back. If you do the math, that's a huge amount of income.

But on the other hand if the market falls, it might be years before you're in a position to do a rollup. So Index Roll can generate lots of income, but the timing is very unpredictable and you shouldn't depend upon it in the short-term.

12) Should I risk losses in a retirement account?

There's an argument that only low risk assets should go in a retirement account, because 1) you can't write off losses in a retirement account, and 2) if you make a mistake in a retirement account, the opportunity to contribute is gone forever.

And because of that reasoning, and because options are more risky than stocks, it follows that options aren't suitable for a retirement account.

But we don't buy the argument. Are we investing for short-term losses? No, we're investing for long-term gains, and huge gains in a retirement account are exactly what we need to fund a stable retirement.

Your retirement account is the ideal place to put long-term investments, and the Index Roll strategy is a long-term investment strategy. To avoid that opportunity just because of some short-term volatility doesn't make sense to us.

13) Can I implement this strategy using Index Options?

We haven't done it, but yes, it should work. LEAPs aren't available for all indices, so your index choices may be limited. For example, we haven't seen an index with international exposure.

If you do some research on this or give it a try, please tell us how it goes. Our understanding is that the pricing is almost identical.

14) Could I sell monthly calls on my LEAPs to make even more money?

Well, you could but you wouldn't want to in the long run. We know it looks promising, but its a mirage. Here's the brief explanation, and feel free to ask further questions if you want more information or are still not convinced.

When you sell a covered call, most months you think you're better off. The premium makes your losses smaller and gives you about the same level of gains.

But its the extremes that get you. When the market takes a major hit, say a 10% drop, it takes forever to work your way back to your previous position when your future returns are capped.

And when the market climbs a lot, you either miss out, or you're stuck having to buy your appreciation back. This may not happen that often, but if you throw out the one month in each year with the highest return, you're cutting your average market returns significantly.

Then there's all of the extra transactions, the bid/ask spread, the time spent, etc. You're going to make your online broker a lot richer.

Now there is one thing you could do - when you buy your LEAP, sell a single call at the same strike price but with a shorter expiry. It doesn't have a big impact in the long run, but it can save you a little money if the market stays flat or goes down in the short term. But once this short call expires, just let it go.

16) Can I use shorter calls? Two years seems like a long time to hold a call.

Well, you could buy one year calls, hold them for six months, sell them, and buy another year at the same strike. But your costs will be higher and all your gains will be short-term.

But are you thinking about a cash strategy? There are some strategies where you buy or sell repeated calls on the Index. These are strategies where you bet $1000 every month to get $2000, with an expected value of $1100, or something like that.

The problem with these strategies are that the cash inflows and outflows are wildly unpredictable in the short term, so even though your spreadsheet says you make 25% a year, you can find yourself halfway through the year and down -200% even though the markets only fallen 15%.

Holding a leveraged index position may sound risky, but if you don't plan on selling it for years, just rolling it over, your cash outflows are predictable in the short term, and your inflows are predictable in the long-term, and that's exactly the way you want it.

17) Can I use puts or spreads instead of calls?

You could. There are lots of ways to be long the index - you can sell puts, buy calls, buy bull call spreads or sell bull put spreads, whatever.

Still, long calls are simple to use, economical, and don't have high transaction costs. They capture all of the upside appreciation and limit your downsides. They don't have margin calls and you're never in a situation where you can get an early exercise.

We recommend you stick to owning LEAP calls. If you want more leverage and capital efficiency, you can always select higher strike prices. Just monitor your roll forward costs very carefully.

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