Downside-Protected Strategies

Trade variations

Of course, this strategy can be implemented differently. In the above example, the trade is set up so the maximum possible loss is (roughly) 0%. But it is possible to set it up so that the worst possible outcome involves a gain. Or the worst possible outcome can involve some degree of loss.

The next figure shows different variations of this limited downside strategy as of the start of March 2025. The blue line shows the minimum strategy payout. It starts at just over 4%, which would have been the return from buying a one-year T-bill and not doing anything with the options at all.

The blue line crosses zero at a strike of 107.2. This means that the payout shown in the first figure would have been constructed by buying an at-the-money call (i.e., whose strike equals the current underlying stock price, or is as close as possible) and by selling a call with a strike price equal to 107.2% of the underlying stock price at the time of the transaction. The orange line shows that the maximum return for the zero-loss case equals 0.069, or 6.9%. (The three middle lines in the figure will be explained shortly.)

By selling a higher strike call, and thus receiving less revenue upfront, the strategy’s maximum payout can be increased, but at the expense of having a larger-than-zero potential loss. As the blue line goes below zero, the orange line – indicating the maximum payout – increases. If one is willing to sell a 114% strike call – the rightmost value shown on the x-axis – then the maximum achievable payout is about 11%, with a maximum loss of just over 2%. The payout from this higher variability version of the strategy is the following:

The three middle lines in the “SPX options” figure show the expected return of the strategy, under different assumptions about the market’s expected return over the next year. Just buying a one-year T-bill would generate an expected return of just over 4%, while the 114 strike (highest variability) version of the strategy generates an expected return between 4.25% and 5%, depending on the underlying return assumption for the SPY.

Trade implementation

If you are an investor interested in implementing this trade, or if you are an advisor and one of your clients is asking you about it, there are a few things to consider:

• How much downside are you or your client willing to tolerate? This will determine the strike of the call option that you are selling (the above illustrations assume the bought option is always struck as close as possible to the current S&P 500 price level). The strike of the sold call will also determine the maximum upside of the strategy and its expected return.
• Is now a good time to enter the trade? Among other things, this depends on whether the current maximum upside of the strategy is high or low relative to its history. The two determinants of that are 1) the current level of short-term interest rates; and 2) the difference in implied volatilities between the 100% strike option you are buying and the upside option that you are selling.² Usually the implied volatility of the 100% strike option is higher, and, the smaller the difference between that and the implied volatility of the upside strike option (which is being sold), the higher the strategy payout.

Unfortunately, the option math underlying the limited downside strategy can get complex pretty quickly. However, for some investors, the limited downside feature of the strategy, combined with a reasonable maximum upside, might provide a better payoff profile than investing directly in the index, or even in a combination of index and Treasury bonds.

It is possible to implement this trade without using outside ETFs, thus lowering your fees.

Appendix

The actual trade implementation that generates the payout figure at the start of the article involves buying a 575 strike call on SPY at a price of $55.89 and selling a 620 strike call at $28.15. At the time this analysis was done, SPY was trading at $576.88. As a result, the all-in cost of the investment is

$576.88 + $55.89 - $28.15 = $604.62.

The $576.88 is used to buy a one-year T-bill, which at the time was yielding 4.06% per year, while the $55.89 - $28.15 = $27.74 is the net amount used to buy the call spread. The value of these two positions when the trade is unwound – the T-bill and the call spread – divided by the original cost of the position, $604.62, gives the percent return shown in the above figures.

For tax purposes, the T-bill and call spread are treated differently. The price appreciation of the T-bill counts as interest income during the time the T-bill is held. The tax treatment of options depends on whether they expire or are exercised, in which case, whether it’s a short- or long-term capital gain depends on the holding period for the stock.

It is possible the trade will not last the entire year until the expiration date of the options because SPY options are American style, which means they can be exercised early. Presumably this would happen only if the upside call sold by the strategy is in-the-money, i.e., SPY is trading above the strike price of the sold call (a good thing for the strategy), in which case, the purchased call option can also be exercised and the underlying stock delivered to the buyer of the sold option.

There are some subtle issues with early exercise of the low-strike call if SPY is trading between that strike and the higher strike of the sold call. But given the low SPY dividend yield, this is unlikely to matter much.

Endnotes

¹ A call option gives the holder the right, but not the obligation, to buy the underlying security, e.g., the SPY ETF, at a prespecified price – called the strike – up to some point in the future, called the maturity.

² The implied volatility of an option is – to a rough approximation – the market’s best guess about how much the stock underlying the option will fluctuate over the life of the option.

Harry Mamaysky is a professor at Columbia Business School and a partner at QuantStreet Capital.

QuantStreet is a registered investment advisor. It offers wealth planning, separately managed accounts, model portfolios and portfolio analytics, as well as consulting services. The firm’s approach is systematic and data-driven, but also shaped by years of investing experience. To work with or learn more about QuantStreet, contact the firm at [email protected].

---

A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out some of our webcasts.

More Cash and Short-Term Funds Topics >