Three DIY structured notes

Industry titans manufacture most, if not all, products you sell. Your job is to understand them and determine which are right for your clients.

But if you have an IIROC options licence, it’s possible to put together your own products — a great way to differentiate yourself from your competitors, which is increasingly difficult in a crowded industry.

Ioulia Tretiakova, vice president and director of Quantitative Strategies at PR Investing, provides the framework for three structured products you can assemble and offer clients with conservative risk profiles.

These trades can be useful for sophisticated investors looking to modify the risk-and-payoff profile of a portion of their portfolio.

Note, you’ll need to open a margin account for the client.

Structure 1: Theoretical Principal Replacement with Equity Upside

Target result: In two years, the investor will theoretically get her principal back, plus 28% of any S&P/TSX60 upside.

Hypothetical trades:

• Take 97.6% of your money and buy a 2-year zero coupon bond.
• Take the remainder and buy a Dec. 2014 call option on the S&P/TSX 60 with a $730 strike price (the approximate price of the S&P/TSX60 at time of writing).

What is happening: The zero coupon bond moves toward par ($100) at maturity, replacing the discount that you used to buy the option. The call provides upside potential equal to 28% of the upside of the index (this upside exposure will change as option prices and interest rates change).

When to use: You think the market may rise but are not willing to expose your capital if you are wrong. You will be happy with some modest participation but protecting your capital is the priority.

Structure 2: Theoretical Partial Replacement of Principal with Equity Upside

Target result: In two years, the investor will get 95% of her principal back plus 87% of the S&P/TSX upside.

Hypothetical trades:

• Buy 92.8% worth of a 2-year zero coupon bond.
• Take the remainder and buy a Dec. 2014 call option on the S&P/TSX60 with a $730 strike price (the approximate price of the S&P/TSX60 at time of writing).

What is happening: The zero coupon bond moves toward par ($100) at maturity, replacing the discount that you used to buy the option. The call provides upside potential equal to about 87% of the upside of the index (this upside exposure will change as option prices and interest rates change).

Less of your capital is buying the bond so you theoretically replace only 95% of the original capital. On the other hand, you have more money to buy calls and participate in more of the possible upside of the index.

When to use: You think the market may rise quite a bit and want as much exposure as possible but are only willing to expose 5% of your capital if you are wrong.

Structure 3: Theoretical Capital-Protected way to benefit from Declining Equities

Target result: In two years, the investor will theoretically get her principal back plus 21% of the S&P/TSX60 downside.

Hypothetical trades:

• Buy 97.6% worth of a 2-year zero coupon bond.
• Take the remainder and buy a Dec. 2014 put option on the S&P/TSX60 with a $730 strike price (the approximate price of the S&P/TSX60 at time of writing).

What is happening: The zero coupon bond moves toward par ($100) at maturity, replacing the discount that you used to buy the option. The put provides upside potential equal to about 21% of the downside of the index (this exposure will change as option prices and interest rates change).

When to use: You think the market may fall and want to participate without exposing too much capital if you are wrong and the market moves higher.

Source: Ioulia Tretiakova, PR Investing

Comments:

• Equity exposure consists of price return only; dividend yield is not included.
• Only nominal principal is theoretically protected, which can be material given the fairly long term of most structured products.
• Attractiveness of payoff depends upon other factors such as level of interest rates and volatility in the markets (impacts derivative pricing).
• Transaction costs are not taken into account, although bid-ask spreads are reflected.
• Contract minimums may restrict your ability to execute trades.