Build A Structured Product Yourself

| About: Freeport-McMoRan Inc. (FCX)

Summary

Structured products are useful in that they help invest money for a specific purpose for a specific time frame.

Typically, structured products are available only to sophisticated investors holding a special status (e.g. accredited investors).

In this article, I show how anyone can build a structured product with widely available instruments.

Many of you may have heard about so-called structured products, which are usually sold by banks to clients with a decent amount of capital (sometimes, to sophisticated/accredited investors only). The idea behind a structured product is simple: it provides a nice expected return with a small (sometimes, zero) risk. This asymmetric risk-return profile is achieved using the mix of stock options and bonds (or like low-risk instruments):

(Source: Investopedia.com)

Although structured products are not a panacea, especially for long investment horizons (as debt instruments tend to underperform equities in the long-run), they are ideal for relatively short-term investments (up to three years or so) or for timed portfolios (i.e., portfolios with specific "exit dates"). For example, if you are saving for a downpayment for a house or a car (i.e., a big purchase), investing in equities is simply not an option -- you have no idea where the stock market may end up, especially given the volatility it has exhibited over the past few years. On the other hand, savings accounts or even certain marketable debt instruments (i.e., Treasuries), barely keep up with inflation. Besides, if the stock market does indeed rally over the next several years, you will miss out on the opportunity. Hence, what you want is some sort of guaranteed return with an option for upside exposure. This is exactly what structured products do. Fortunately, I will show you a way to build a structured product by yourself without a large investment or a special status. All you need is a basic knowledge of equity options and a broker that lets you freely buy and sell options.

Selecting the "fixed" part of the structured product

The "fixed" part of the structured product is a part that will bring you a guaranteed return with little or no volatility around itself. An ideal instrument for this is some sort of short-term bond that will mature at the exact time when you need to liquidate your portfolio. For this example, however, I will take the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT). While this instrument is not exactly a bond but, rather, an equity-like instrument with exposure to a diversified portfolio of debt instruments, it is the most readily accessible instrument for all investors reading this text. The reason is simple -- it trades like a stock, and you can purchase and dispose of it any time you want. Of course, there is a certain cost associated with that: because it is a market instrument, it is exposed to market volatility, which may be substantial, as we will see later.

The best part about this instrument is that it is negatively correlated with the stock market (at least in the short term):

Click to enlarge

(Source: Google Finance)

Over the long term, the ETF seems to grow in value. In addition, it pays a decent 2%+ annual dividend yield, which partially compensates for its price volatility. Its Sharpe ratio is actually around 1.0 or higher, which is rare for market instruments (typically, you have a lot of volatility for a unit of expected return). I think this is a good "base" of the structured product, based on its risk-return characteristics, marketability and liquidity.

You do not have to choose this exact instrument or ETFs in general. If you have the money, go ahead and buy bonds directly with the preferred yields and maturities. Other marketable alternatives include Vanguard Total Bond Market ETF (NYSEARCA:BND) and iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG).

Selecting the "variable" part of the structured product

The "variable" part of the structured product is ostensibly the equity option. I am choosing options readily available to retail investors. These options typically do not exceed a 1.5-year duration period. That is, the longest-tenor options investors can choose now expire in January-February 2018. I personally recommend that investors choose options on broad index ETFs like the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) and Vanguard Total Stock Market ETF (NYSEARCA:VTI). This is because they tend to have a lower volatility of returns than single stocks (and greater "surety" of returns). In addition, I recommend using option spreads (e.g., call spreads) rather than simply buying calls or puts. The reasons for that are simple: option spreads are cheaper (because you buy one option and simultaneously sell another option of the same kind and duration but with a different exercise price), which means they will take a smaller portion of the value of your structured product, and are more predictable because you know your maximum upside with the position (you lock in an expected return) and maximum risk (i.e., maximum loss).

However, in my case, I am using a call spread on options expiring on Freeport-McMoRan (NYSE:FCX), expiring in January 2018:

(Source: optionsprofitcalculator.com)

There are a few reasons for that:

(1) The absolute cost of this spread is very low -- if you are investing as little as $1,000 into the structured product, this call spread will cost you less than 8% of the structured product's value. If you are using the proposed bond ETF, it can only gain as much as 5% in price over the next 18 months given the current dividend yield.

(2) There has been a lot of talk recently about the turnaround of the commodities cycle. As a result, the company's stock has gained about 65% since the start of the year:

Click to enlarge

(Source: ​Google Finance)

(3) The options are cheap in relation to their historical implied volatility:

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Click to enlarge

(Source: ​optionistics.com)

As you can see from the charts above, the options are currently trading near their all-time lows.

(4) The stock's long-term options are liquid, which is very important for modeling purposes (i.e., we can trust the quoted prices and use them in calculations):

Click to enlarge

(Source: ​Google Finance)

Note that I have specifically chosen in-the-money calls for buying purposes. I could, of course, use an out-of-money call spread, which would be cheaper overall (only paying for time value), but upside opportunities are slimmer with these derivatives. By buying in-the-money calls I am balancing a high chance of staying in-the-money (currently around 70%, according to the option's delta) with the overall cost of the spread (deeper in-the-money options would be more expensive in absolute terms and bear more downside risk in the event the stock turned south and stayed there until the option's expiration). The risk-reward profile of the call spread looks as follows:

(Source: optionsprofitcalculator.com)

Note that the break-even point is below the current market price of the stock. This is exactly why I prefer buying in-the-money calls in the long term, despite the more favorable risk-reward ratios of the more leveraged out-of-money options.

Here is the overall profile of the structured product encompassing all information necessary:

Click to enlarge

(Source: various. ​Calculations by author)

From the above illustration, you can derive a few valuable pieces of information:

  • The size of the structured product is pretty small, which makes it affordable and scalable.
  • Because the structured product only involves three trades (buying the ETF, buying and selling the calls), it is very cheap in terms of transaction costs.
  • The maximum return on the structured product is around 26% per annum (over 30% on the 18-month term), while the risk is just over 17% (around 20%-22% over the 18-month period due to the nature of standard deviation).
  • The maximum risk (loss) is only achievable if the stock ends up trading below the break-even price (around $10.73 per share, which is 4% below the current market price of the stock), and if the bond ETF tanks (almost a perfect storm scenario given the fact that TLT is negatively correlated with most stocks, at least in the short term, due to the nature of the products it is composed of).
  • You can change the risk-reward profile of the structured product by shifting weights around. For example, if you increase the options' share in the overall structure to 13% of the product's value (essentially, double the proportion), your risk-reward ratio will also change to an expected return of 28% at a risk of almost 23% (i.e., increase the expected return by ~2.5% by increasing risk by almost 6% -- not a great rate of change at all). Clearly, if capital preservation is your key priority, leaving the weights where they are initially is your best choice.

Conclusion

In this article you have seen an example of a do-it-yourself structured product, which will enable you to capture the benefits of this type of financial instrument without the capital requirements or status usually required to participate in this kind of investment vehicles. To recap, structured products are ideal for timed portfolios. They are also interesting from the risk's standpoint in that a large portion of their value bears little to no exposure to market volatility. At the same time, they are not closed to upside exposure, which is a typical situation with vanilla bonds and various bank products (e.g., savings account, GICs, etc.). I suggest that investors ​learn more about these products and view them as an alternative to more conventional investments.

See calculations here.

Disclosure: I am/we are long SPY, TLT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.