Preservation of Principal WITH Market Upside:


I'm starting off a series of posts on Financial Models with various objectives that investors and savers alike are sure to find interesting. I will be sharing Financial Models that can do everything from preserve principal while affording market upside gains, to hedging, to exploiting leveraged moves up or down with capped downside protection.








Financial Model #1 is a Principal Preservation model whereby one cannot lose money, yet can benefit from upside market moves. This can be done rather simply by combining the income from a CD, high yield money market, or a bond WITH remaining funds allocated to call options on the S&P500. As you can see, starting in Aug 2008 and with a term ending at the end of Dec 2009, one can lock in a nominal gain of 2.1% even in a down market. However, while being afforded this protection, you don't have to sit it out and you can benefit partially from the upside movement.




How did I do it?

Well, for a hypothetical $100,000 to invest (these methods are scalable), you take $95,600 and invest it in a CD yielding 4.5%. At the end of the term, that portion is worth $102,125. With the remaining $4,400, you buy 4 at the money calls on SPY (S&P500 ETF) to expire in Dec09. At the $135 strike, these cost $1100 each. You've now invested the $100,000 and will realize the returns listed below. I set this one up so you're net positive in a down market and you get a 50% benefit of the market return on the upside.



Note: I simply highlighted one example. Unlimited iterations exist. I have a spreadsheet set up for easy manipulation. For instance, you could buy out of the money options for less and realize a larger gain for large market moves over the time period. You could alter the amount invested in CDs vs. options.

Also note that these are total returns during the 17 month period or so, not annualized.

What scenarios would this be good for?

• Fixed income situation where a marginal loss to inflation is OK, but preservation of principal is paramount. Willing to give up a slightly higher guaranteed yield for opportunity to participate in market upside potential.


• If you need the funds in a short horizon, yet want the opportunity to participate in market runup. For instance, if your kid is starting college in 2 years and you know you have enough now, but want to afford yourself the opportunity to participate in upside.

When you shouldn't use a model like this:

• If you're solely interested in optimal income, you could have a guaranteed income at greater than 2.1% and avoid the market altogether.


• If your time horizon is like 30 years in a retirement planning scenario, it probably makes the most sense to take a more aggressive approach to maximize gains over the long term and ride out any near term volatility. Stocks always outperform cash, bonds and other income investments over 20+ year time periods.

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