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Managing Downside Risk in Retirement Planning

October 27, 2009

by Geoff Considine, Ph.D.

Stress testing

Now let’s look at how the effectiveness of this strategy holds up to various stresses.  First, let’s assume that we end up paying more than fair value for the call options.  Let’s assume that we paid 25% more than fair value for the two-year options.  This might occur because of temporary but extreme market dislocations.  This reduces the effective leverage that we get with the call options: You can afford a smaller number of call options with the 10% of the portfolio allotted to options purchases.

Stress Test
Stress test in which we pay 25% too much for call options

In the case that we pay 25% too much for the call options, the strategy still holds up: We have much less downside than we would with equities, while retaining considerable potential upside from a rally in equities.  The effectiveness of the strategy is not highly sensitive to the valuation of the options.  The main impact of paying too much for the options is that the effective leverage ratio decreases. 

One of the obvious variations on Bodie’s strategy is to purchase call options on indexes other than the S&P 500.  One might choose to invest in calls in a range of core asset classes or split between multiple indexes.  Many of the potentially desirable asset classes for applying this strategy, however, do not have options markets stretching out as far into the future as the S&P 500 does, which is why I have used the S&P 500 in my baseline analysis. 

The chart below shows the basic 90/10 strategy implemented with call options on the NASDAQ 100 index (QQQQ) rather than on the S&P 500, but this strategy is implemented using options with a one-year expiration, because the longest-dated options on QQQQ do not go out two years:

90/10 Portfolio
90/10 portfolio with call options on QQQQ