Goldman Sachs recommends using long-dated equity call options to maintain equity upside participation while reducing late-cycle drawdown risk

Overview

This report discusses how asset allocators can stay invested after strong equity gains by replacing part of their equity exposure with long-dated equity call options. The core approach is to buy long-dated S&P 500 call options and allocate the freed-up capital to T-bills or short-duration investment-grade credit. Goldman Sachs believes that long-dated call options are not merely simple delta substitutes; their embedded leverage, limited downside risk, and convexity can help investors more flexibly tailor return and drawdown characteristics in a late-cycle environment.

Core views

Goldman Sachs' core view is that 2-year 25-delta call options offer a superior balance among capturing upside convexity, reducing negative carry, and controlling drawdowns. Compared with short-dated options, long-dated call options benefit more in a sustained rally, especially in an environment where equities rise while implied volatility also increases; at the same time, their lower time decay results in better carry efficiency. The report prefers rolling 2-year call options 1 year before expiry and using progressive rolling to diversify the path dependence associated with any single roll month.

Analysis framework

The report decomposes the total return of long-dated call option strategies into five components: starting delta, path delta, vega, option carry, and funding, and compares risk-return performance across different maturities, deltas, roll timings, and option notionals. The analysis primarily focuses on S&P 500 long-dated call options, while also extending to 60/40 portfolio risk mitigation, cross-asset volatility, correlation, skew, term structure, systematic equity strategies, and cross-asset option overlays.

Methodology notes

• Option return decompositionFive-factor option return decomposition

  starting delta, path delta, vega, option carry, funding

  Starting delta measures the contribution of initial market exposure; path delta measures the additional profit and loss from changes in option delta along the market path; vega measures the contribution from changes in implied volatility; option carry reflects the effects of time decay, gamma, and higher-order Greeks after excluding delta and vega; funding measures the difference in financing and cash returns when options are used instead of spot equities.

• Portfolio constructionEquity replacement plus credit asset allocation

  Long-dated call options plus IG credit

  After replacing equity exposure with long-dated call options, the remaining capital can be allocated to T-bills or short-duration investment-grade credit to improve carry and enhance downside characteristics while preserving equity upside participation.

• Rolling mechanismProgressive rolling

  Diversifying roll months

  The report notes that long-dated option performance is highly sensitive to the roll month, and therefore prefers allocating capital evenly across multiple sub-strategies with different roll months to reduce the impact of any single roll date on long-term performance.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• S&P 500

  Core underlying and equity exposure replacement target

  Strengths

  High liquidity and a deep options market, making it suitable for building long-dated call option replacement strategies.

  Weaknesses

  In a sharp early-cycle rebound after a bear market, long-dated out-of-the-money call options may lag spot equities because delta rises with a delay.

  Comparison

  Compared with holding the S&P 500 directly, long-dated call options can provide limited downside and upside convexity, but performance depends more on path, volatility, and roll timing.

  Risks

  Equity declines, falling implied volatility, unfavorable roll timing, and changes in funding and dividend assumptions.

• 2-year 25-delta call options

  The report's preferred long-dated equity option structure

  Strengths

  Provides a good balance among path delta, vega, and carry, making it suitable for late-cycle sustained rally scenarios.

  Weaknesses

  Still has negative carry, and protection is limited in brief or shallow drawdowns.

  Comparison

  Compared with short-dated options, time decay is lower; compared with 50-delta options, convexity is stronger.

  Risks

  Mean reversion after buying at high implied volatility, and carry drag when the market is trendless or range-bound.

• USD IG 1-3y

  Cash reallocation asset in the option replacement strategy

  Strengths

  Can improve portfolio carry; the report says it has added about 1.4% p.a. relative to T-bills since 1996.

  Weaknesses

  Exposed to credit spread and interest rate risk.

  Comparison

  Offers higher returns than T-bills, but with weaker defensive properties.

  Risks

  Widening credit spreads, short-end rate volatility, and liquidity stress.

• T-bills

  Base allocation asset for residual cash in the option portfolio

  Strengths

  High liquidity and safety, making them useful as the cash benchmark in return decomposition.

  Weaknesses

  Yields may be lower than short-duration investment-grade credit.

  Comparison

  Compared with USD IG 1-3y, carry is lower but credit risk is also lower.

  Risks

  Falling reinvestment income and inflation eroding real returns.

• Cross-asset option overlay

  Extended tail-risk and risk-mitigation tool

  Strengths

  Can use the sensitivities of different assets to global growth, monetary policy, oil prices, or market reversals to construct hedges.

  Weaknesses

  Depends on correlation and volatility pricing, and the structures are complex.

  Comparison

  Compared with single-equity options, it can provide more diversified risk-factor coverage.

  Risks

  Correlation breakdown, excessively high implied volatility, and mismatch between hedge instruments and portfolio risks.

Key data

• Preferred option structure2-year 25-delta call optionsThe report argues that this structure captures convexity from path delta and vega effectively, while carrying less negative carry than short-dated options.
• Benchmark replacement structure4x 2y 25D calls + USD IG 1-3yUsed to achieve an equity replacement exposure with an initial delta of about 100.
• Defensive position size3.2x 2y 25D callsThe goal is to achieve upside similar to the top 5% of S&P 500 gains while reducing downside risk.
• Aggressive position size6.9x 2y 25D callsThe goal is to achieve downside risk similar to the S&P 500 while significantly amplifying right-tail returns, with average delta around 280%.
• Rolling preferenceRoll 1 year before expiryRolling 4x 2-year 25-delta call options 1 year before expiry can improve annual option carry contribution by about 1.6 percentage points.
• Roll timing sensitivityThe gap between the highest and lowest annualized return is about 7 percentage pointsThe performance of 2-year call option strategies across 24 different roll months varies significantly, indicating that the roll date itself can materially affect outcomes.
• Short-duration IG credit benefitAbout +1.4% p.a. since 1996The report states that replacing T-bills with short-duration investment-grade credit can improve portfolio returns.
• S&P 500 benchmark performanceTotal return 10.6%, volatility 19%, maximum drawdown -55%Benchmark metrics for the long-term S&P 500 sample shown in the appendix table.
• 2y 25D 4x rolled 1 year before expiryTotal return 9.9%, volatility 18%, maximum drawdown -40%The appendix table shows that this structure reduces maximum drawdown relative to the S&P 500, but with slightly lower total return.
• 2y 25D 6.9x rolled 1 year before expiryTotal return 13.7%, volatility 29%, maximum drawdown -63%This upside-convexity structure increases total return and right-tail gains, but also comes with higher volatility and maximum drawdown.

Impact & implications

For asset allocation, the report provides a way to manage late-cycle risk without fully exiting the equity market: retain upside through long-dated call options, deploy freed-up cash into higher-carry assets, and shift between defensive and aggressive positioning through different option notionals. This framework also suggests that option replacement strategies cannot be assessed solely on initial delta; roll rules, implied volatility levels, market trends, term structure, and funding/dividend assumptions must also be evaluated.

Risks

• Long-dated call options have negative carry, and if the market moves sideways or gains are insufficient, the option replacement strategy may underperform spot equities.
• The strategy is highly sensitive to roll timing, and a single roll date may create significant path dependence.
• In a sharp early-cycle rebound after a bear market, out-of-the-money long-dated call options may not participate sufficiently in the upside because of their low starting delta.
• If implied volatility falls from elevated levels, vega contribution may drag on returns.
• Changes in interest rates, funding spreads, and dividend expectations can affect option pricing and strategy returns.
• Allocating to short-duration investment-grade credit introduces credit spread and liquidity risk.

What to watch

• The strength of the S&P 500 trend and its position relative to moving averages, because path delta is highly trend-dependent.
• The historical percentile of long-dated implied volatility and the risk of mean reversion.
• Option roll rules, especially whether rolling 1 year before expiry and progressive rolling are used.
• U.S. equity concentration and technology stock risk, because the report emphasizes rising equity risk and Tech concentration.
• Funding spreads, short-end interest rates, and dividend yield expectations.
• Whether cross-asset volatility, correlation, skew, and term structure indicate changes in tail-risk pricing.