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.

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

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.

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.

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.

Wilson’s Million Dollar Baby This is the most annotated and fleshed out model we have, but its a little old. Simulates a fictional couple (the Wilsons) who creates an investment schedule in which they will buy options on three index ETFs, SPY, MDY, and EFA. The target is to have a $900k portfolio of diversified ETFs within three years. Each year, they purchase about $50-60k worth of options. Their rollover costs will start at $7k a year and will peak at $20k a year. They plan on using a roll-up in year four to raise more cash to invest by selling the options bought in Year 0 and buying new ones. The benefit is reduced cashflow in Year 4, which reduces the overall out of pocket costs.??By the end of ten years, the ETF portfolio will be worth $1.8m. After subracting the strike prices, they'll have $1.1m, which will give them plenty of financial freedom. The best part of the model is that as we project cumulative cashflow, including purchases, sales, rollovers, etc, they're never out of pocket more than about $200,000, which is very manageable for our fictional couple Note: This is a complex model that uses ratios to predict roll forward costs. It places a floor under the roll forward costs of 1%, which may or may not be accurate, but is meant to reflect the bid/ask spread. Also, over 10 years its very likely that roll-ups would be required, generating additional cash. http://www.indexroll.com/million-dollar-baby.xls One of our readers helped create this spreadsheet and did an excellent job. It runs the index roll for ten years one hundred times and calculates the average returns. Nice comparison to margin. Built-in black scholes macro. http://www.indexroll.com/IR-Comparison.xls We modified the spreadsheet for IWN, the small-cap value ETF. http://www.indexroll.com/IR-IWN-Comparison.xls

1) How do I diversify against this strategy? 2) I'm interested in income. Would this help me? 3) Should I risk losses in a retirement account? 4) Can I implement this strategy using Index Options? 5) Could I sell monthly calls on my LEAPs to make even more money? 6) Can I use shorter calls? Two years seems like a long time to hold a call. 7) Can I use puts or spreads instead of calls?