Many investors remember the most recent financial crisis and the toll that it took, not only on their retirement portfolio, but also their sanity. The subsequent impact of this event left many jaded in terms of trusting markets with their longterm savings. One of the unfortunate consequences of experiencing such a market event was seeking alternative investment strategies that could provide great returns with limited downside risk. One of these strategies involves the use of call options and Treasury Inflation Protected Securities, or TIPS.
Originally proposed by Boston University professor Zvi Bodie in 1995, the strategy involves placing 90% of your asset allocation in TIPS and using the remaining 10% to buy call options on an index such as the S&P 500. The sales pitch goes something like, you will at the very least earn the return of TIPS, which allows your money to maintain its purchasing power over time as well the ability to capture the potential upside of the S&P 500 via the call option.
The easiest way to explain the payoff structure of this strategy is to break it down into its parts: the TIPS and the call option.
TIPS: Removing the Unexpected
U.S. Treasury Inflation Protected Securities (TIPS) are a relatively new instrument (1997) for investors to use to manage their investment goals. Think of them as similar to a basic U.S Treasury Note or Bond, but the difference is that the principal of your TIPS bonds are adjusted for inflation and, therefore, your coupon payments. For example, if over the last 6 months the CPI (measure for inflation) increased by 1.5%, then you would expect your principal and corresponding coupon payment to increase by 1.5% as well.
TIPS are one way for investors to hedge inflation (i.e. real purchasing power) risk. But it is important to remember that hedging this risk does not come free. Just like paying an insurance company a premium for hedging car, home, flood, or health insurance, investors must pay a premium in the form of higher prices (lower real yields) in order to completely remove the threat of inflation.
What does this look like?
Let’s compare two different bonds: one is a simple 1Year“ish” U.S. Treasury Note expiring 01/15/2019 and the other is a 1Year“ish” TIPS expiring on the same date. Using data from the Wall Street Journal, we can see that 1Y U.S. TNotes are currently trading at 99.7734 with a 1.125% coupon for an overall yield of 1.297%. This yield is referred to as the “nominal yield” which is made up of two different components:
 Real Rate of Return Component: this is broken down further into two parts:
 Real Rate – the actual cost of borrow absent inflation
 Term Risk – the risk associated with changes in the real rate of return
 Inflation Component: this is also broken down into two parts:

 Expected Inflation: what the market has determined to be the rise in the cost of general goods and services
 Risk of Unexpected Inflation: the risk associated with actual inflation being different than expected inflation
Using the same data from The Wall Street Journal, a 1Y U.S. TIPS is currently trading at 103.06 with a 2.125% coupon for an overall yield of 0.264%. This represents the combination of the real rate of return determined by the market as well as the cost of hedging the risk of unexpected inflation. Is that an actual “negative yield” meaning investors are willing to pay the U.S. Government to lend them money? Yes it is, and we will explain this phenomenon in a second.
What this 0.264% yield implies is that “expected inflation” determined by market participants over the next 15 months is 1.561%. How did we arrive at this number? Take the nominal yield of 1.297% for the 1Y U.S. TNote and subtract the 0.264% real rate of return determined by the 1Y U.S. TIPS and we arrive at expected inflation.
How is it possible that real rates of return are actually negative? The simplest answer has to deal with a “flight to safety” by investors. Given the uncertainty surrounding the global economy, whether or not central banks around the world will adjust interest rates, or the longterm effects of an increase in the money supply, investors are willing to accept negative returns (i.e. pay a steep price) in terms of real purchasing power in order to protect themselves. Given the large amount of quantitative easing performed by the Federal Reserve over the last 5 years, market participants are concerned about the unexpected rise in inflation once that money starts to be circulated again in our global economy.
What is important for investors to understand is that there is the potential to experience negative returns by holding TIPS in periods where the threat of inflation is high. This is the “premium” we were referring to earlier. It doesn’t necessarily mean that it will always be negative, but more often than not it is going to be lower than the return on regular U.S. Treasury Notes. For example, for the 5year period ending 08/31/2017, the BofA Merrill Lynch 15 Year US Treasury and Agency Index has delivered a 0.92% annualized return while the Bloomberg Barclays U.S. TIPS Index 15 Years has delivered a 0.24% return. When the threat of inflation is extremely high, just like the threat of a flood if you live in a flood zone or a car accident if you live in a highly populated area, expect to pay a premium for that protection in the form of lower yields.
Options: Trading Volatility
When discussing the use of options in an investment strategy, it is important to understand the key components of option pricing. Let’s first discuss what options are and what they do.
Options are contracts in which the investor has the right but not the obligation to buy or sell an underlying asset at a given price. A call options allows an investor buy a particular asset at a given price while a put option allows investors to sell a particular asset at a given price. Their primary use is for hedging certain risks (i.e. insurance) or to speculate about the future value of a particular asset.
Key determinants of the price of a particular call or put option are:
 Current price of the underlying asset (stock, bond, commodity, etc.)
 Strike Price
 Time to Expiration
 Riskfree interest rate (TBills, LIBOR, TNotes, etc.)
 Volatility
Options markets are highly competitive, just like the general stock market. Given this highly competitive nature, we would expect option prices to be relatively “fair” in terms of what they are pricing.
What exactly are the options markets pricing?
In an options contract, there are 4 known variables. We know the current price of the underlying asset, we know the strike price, we know the time to expiration of the contract and we have a good idea what the riskfree rate is. Given these 4 known variables, we can determine that options markets are pricing volatility expectations when in equilibrium just like stock markets are pricing risk in equilibrium.
Let’s give an example.
Apple Inc. (AAPL) is currently trading around $160 per share. If we look at Apple’s option chain sheets from NASDAQ, we can find a series of call and put options. There is an options contract that expires in January of 2019 with a strike price of 160 (i.e. at the money) that is currently trading at $18.30 per contract. An investor who is long the 160 Call on AAPL will earn a positive return if the price of AAPL increases above $178.30 ($160 strike price $18.30 price of the option) between now and January 18, 2019.
We can also look at the price of a put option to determine what the expectation is for AAPL on the downside. The price of a 160 Put on AAPL with the same expiration date is $18.35 or about the same as the call. A put holder of AAPL will receive a positive return if AAPL falls below $141.65.
Based on these variables, the market has determined that the expected volatility for AAPL over the next 15months is 11% to upside and 11% to the downside. To give some perspective, the standard deviation of AAPL so far this year has been about 12% based on daily closing prices. What this means is that if market volatility for AAPL stays about the same, a 160 Call option or a 160 Put Option AAPL will essentially breakeven ($0 profits) depending on which way AAPL moves. This is exactly what we would expect in a competitive options market. Market participants are essentially saying that they do not expect anything out of the ordinary for AAPL over the next 15 months.
Options pay off significantly when something out of the ordinary does happen. Tim Cook, Apple's CEO, decides to leave or maybe there is a major lawsuit etc. But what investors should realize is that using call or put options is essentially a bet on expected volatility over a given time horizon. If volatility is what was expected in your given direction (upside or downside), then you essentially earned the riskfree rate of return (i.e TBills, TNotes, LIBOR, etc.) If it is less, you lose money. If it is greater, you make money.
Putting It All Together:
We explained the two components of Professor Bodie’s strategy. Now let’s describe the payoffs when the two pieces are combined.
Volatility is Less than Expected to the Upside
 Call Option – expires “in the money” but the profit earned on the contract is negative
 TIPS – we earn the realrate of return plus actual inflation
Volatility is as Expected to the Upside
 Call Option – expires “in the money” and we essentially earn the riskfree rate of return
 TIPS – we earn the realrate of return plus actual inflation
Volatility is Greater Than Expected to the Upside
 Call Option – expires “in the money” and profits have the potential to be infinite
 TIPS – we earn the realrate of return plus actual inflation
Volatility is Greater, Less, or as Expected, but to the Downside
 Call Option – expires “out of the money” and the investor loses money in the amount of the price of the contract
 TIPS – earn the real rate of return plus actual inflation
An investor will always earn the real rate of return plus actual inflation on the TIPS, which can be negative if the threat of inflation is high. The call option will only provide a meaningful benefit if volatility is greater than expected to the upside. The investor’s floor in terms of overall return is the real rate of return plus actual inflation minus the cost of the option contracts with the potential for unlimited upside.
What We Expect Over the Long Term
Now unfortunately we don't have readily available data about the performance of this strategy so that we can really look "under the hood" to see how it pays off based on empirical evidence. If anyone is reading this and has actual performance data on this strategy, please send it our way.
We have written about other options strategies before and their performance here and here and the results are always worse than what we would expect by just buying and holding the overall market. With that said, we can only speak about this particular strategy in terms of the theoretical (market efficiency, equilibrium, etc.).
Historically, volatility in markets has been almost, but not perfectly, symmetrical. For simplicity, let's just define risk and volatilty in terms of standard deviation, which we know is not a complete depiction of market risk. The chart below shows the 1month rolling returns for IFA Index Portfolio 100 from January 1, 1928 to August 31, 2017. Notice the bellshape curve and the rough symmetry of the distribution of returns.
^{Sources, Updates and Disclosures: ifabt.com}
There are definitely bouts of extreme volatility to the downside (black swans) but there have also been bouts of extreme volatility to the upside as well (green swans). Given this rough symmetry, over the long term, we would expect the payoff of just the long call options to be negative. Half of the time, the contract would expire "out of the money" (when volatility is to the downside) and half of the time the contract would be "in the money" (when volatility is to the upside). If investor expectations are the best estimate of volatilty, then the payoff of the call option will approximately be the riskfree rate (TBills, etc.). There will be times where the options will win big, but they will be washed away by the many contracts that will expire “out of the money” or “in the money” but unprofitable.
The TIPS are expected to perform slightly less than nominal U.S. Treasury Bonds of similar maturities because of the cost of hedging the unexpected inflation component of the bond (i.e. insurance).
An example may help.
If an investor has a $1,000,000 portfolio and decides to implement this strategy, they will buy $900,000 in TIPS and $100,000 in call options on the S&P 500. Depending on cost of the contracts, an investor may end up losing a decent portion of their portfolio if the contract does not earn a profit. For example, the current cost of a call option expiring in a day with a strike price equal to the current price on SPY (S&P 500 ETF) is $25. That means 1 contact costs $2,500 (price x 100 shares). If the call option is not profitable, the investor just lost close to 0.25% of their portfolio. This is just one example of a call option that is “at the money.” A call option that is currently “out of the money” with a similar expiration costs $5.84, or $584 total (0.058%)
We would expect the longterm return of US TIPS, depending on their maturity, to be less than the return of a nominal U.S. Treasury Bond of the same maturity. For comparison purposes, if we just look at the longterm performance of 5Year U.S. Treasury Notes, the nominal return has been about 5%. We would expect the investor to lose more often than win with the call option strategy even though they will experience some big wins and forgo some large losses. Putting it all together, our best expectation of the payoff of this strategy will be slightly less than 5%.
In comparison, IFA Index Portfolio 10 has delivered an annualized return of 4.5% over the last 89 years and 5.5% based on the median outcome of over 720 monthly rolling 60year holding periods, which we believe is a more accurate expectation. If you knew in advance how markets were going to perform, then Professor Bodie’s strategy could be advantageous, but because we cannot predict market movements with a high degree of accuracy, this strategy is really just an expensive way of hedging inflation and downside risk. A much better alternative would be to buy, hold, and rebalance a globally diversified portfolio of index funds with a risk exposure that matches an investor’s individual risk capacity.
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About the Authors
Tom Allen
Tom Allen is an Accredited Investment Fiduciary (AIFÂ®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFAÂ®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.
Mark Hebner  Founder, Index Fund Advisors, Inc. Â
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.