11/18/2013

Customizing your investment strategy with structured notes

This week we look at the specific advantages of structured products as a way to customize a stock purchase.

Why are we interested?

Ford revolutionized the car industry with the introduction of the Model T.  It was the first real standardized car.  Based on the pictures, they all came in black.  Forget about customizing…I don’t think you could even choose a color! Fast forward to today and you can buy a Ford or any other car in multiple colors, choose your wheel size (and cool rims), add all sorts of systems, and so on.  The car has both mass customization (packaged add-ons) and more specialized customization.  In today’s Deconstructed Notes, we will analyze how structured products can offer a user-friendly experience along with precise customization capabilities when purchasing an investment strategy.

Stocks, like automobiles, have evolved from the early days but the big question is how customized can you get today?  The answer, by the way, is “very” if you choose to utilize a well-conceived structured product, as we will see below.

For illustrative purpose, assume I have a neutral view of the market but I want to invest in SPY.  I don’t want to spend the market value to “buy” returns over 10%.  At the same time — in case I’m very wrong on the market — I want to protect myself against losses of, say, more than 30%.  This seems like a reasonable ask: customization of a stock.

Standardized options began in the 70’s thanks to the CBOE and work of Black, Scholes, and Merton, and the listed options market continues to grow to this day.  I am a big proponent of standardized options, but the fact is they can be a bit difficult to use.  The end investor needs to figure out dates and strikes and percentages, and essentially put together a strategy on his or her own. It is a bit of a DIY product.

While some strategies, such as covered call strategies, have been effectively placed in funds, I believe there are additional and more user friendly (as compared to listed option) opportunities to customize investments.  The solution is the Structured Product, which combines the necessary derivative components in one vehicle, removing the investor’s need to decide how to construct and purchase the various necessary options of a specific strategy. That customization element and the ability to deliver it in a single package can be very powerful if done correctly.  Of course, there is a price to pay for customization.  There is significant credit risk in today’s structured products market, along with potential transparency, liquidity and cost issues.  But with time, technology and adoption, other industries have innovated and/or become more efficient – and I strongly believe the structured product market, which has already made some strides over the last few years, has the potential to do the same.

Now stepping back to how one may customize a stock investment, one must first realize that making a stock purchase is a bit different than non-investment purchases.  With most non-investment purchases the value only goes one way and you are paying for the use of the product.  When you make a stock investment, however, you are essentially purchasing a stake in a company whereby you gain money if the investment increases and lose money if it decreases. The ability to customize a stock investment means an investor can create exposure to the part of the investment he is truly interested in and, conversely, protect himself from the part or parts where he believes there is the most downside  — with the given that no downside risk means no upside potential.

 

Now, let’s get into some details:

I need to slice and dice the SPY into 10% sectors to see what the probabilities and associated values should be, and how I might be able to view more customizable product from this perspective!

The entire upside should simply be equal to an at-the-money call, and the entire downside should equal an at-the-money put.  Using the CBOE calculator, it is confirmed!  We are roughly .1% off on values (call = 8.2%, put = -11.1%) which I believe is acceptable for this illustration. By the way, buying the call and selling the put is essentially equal to buying the security (less the dividend and hence the savings on the call+put combination – we discuss why the dividend is left out further below).  The following chart illustrates the exact investment position of purchasing SPY or any other security for that matter – the potential appreciation and exposure of the investment.

PMC EXC 1309 blog custom simulation table

 

PMC EXC 1309 blog custom log dist graph

 

I ran 2,500 simulations of SPY returns over two years using a Monte Carlo engine.  As may be noted, the value of the ranges on the downside (-11.1%) is more than the value of the upside (8.2%).  This is primarily due to the fact that the simulator range values do not include the dividend amount which is roughly 4% for the period in question, though other elements also come into play (e.g., risk free rate, volatility skew).  I do not include the dividend because derivatives do not pay a dividend, only the underlying security does.  If an investor owns a call and is interested in capturing a dividend they must exercise and convert into the underlying security to capture it.

The way to calculate the range value is to simply multiply the % of simulations by the average value within the range.  So for example, the % of simulations within the 0% to 10% range is 15.5%, which is then multiplied by the average value in that range of 5.1%, to equate to a value of 0.8%.  That means that if an investor only wanted a gain if the SPY had a return profile of between 0% and 10%, and in all other instances the investor will not incur a loss or generate a gain, then the fair value cost according to my simulation would be 0.8%.  Essentially, this is the probability of SPY ending in that range multiplied by the average value of that range.

So with the table above, I can now really analyze what risks I am willing to take and what reward makes sense to me.  For example, I can make a decision that I have no interest in paying for returns greater than 30%, which costs 3.8% according to our chart.  In that way I can decide to save some of that 3.8% by not paying for that payoff.

PMC EXC 1309 blog custom call-spread diagr

Getting a touch more complex, in the example above, I would probably still want to be paid if the stock increased above 30% but would not want to share in the increases above 30%. This is essentially a call spread. In that case, I would need to multiply the probability that SPY increased over 30% by the cap on returns, which is 30%. Using the table above, 8.7% (30%+ ranges) multiplied by 30% is 2.6%. That means that I actually save 1.4% of the cost associated by limiting our returns to 30% or less.

If I wanted to save the full 3.8% because I simply could not envision SPY increasing more than 30% over the time period, I can purchase a knockout call. In a knockout call, once the value exceeds a certain level, the option is “knocked out” and ceases to exist. These products are available over the counter and in structured notes but not on the listed market.

A structured note is traditionally a pre-packaged security. If an investor came in (“reverse inquiry”) with the characteristics of a strategy as in above, the savings (ignoring yields and fees) discussed above would most likely either be applied as a level of downside protection or an additional yield.

 

Takeaway

Derivatives allow the investor to customize the exact tradeoff between risk and reward of an investment.   The catch is that working with derivatives is challenging for many retail investors.  The value that structured notes brings to the table is that they deliver pre-packaged tradeoffs without investors having to understand the details of how to build them – going back to the car example, when customers buy a car, they don’t need or want to know how their car is built (with the exception of maybe my brother-in-law).  They just want to know that it works, it’s reliable, and that it will get them to their location comfortably and safely.

The onus on the banking industry is to make sure that structured notes are similarly appealing– they do what they are supposed to, they don’t surprise investors, and they are easy to access and understand.