Mechanics of a structured product - help structured, discount, product, current, offered

Elliotbay

A friend approached me today to evaluate a structured product offered by his advisor. I am not well versed with SP mechanics so I hope that some of you could perhaps share your insight as to the inner workings of this product. (risks etc)

2 yr term

Choose any 2 stocks that you would not mind owning at 30-40 % discount to current trading levels. If I am not mistaken there is a volatility criterion.

You get paid 1%/month till the end of the the term (2 years) unless the stock trades at pre -determined price (i.e. 30-40% level below current value). In this case, you own the stock and the contract is finished.

I think there is probably more to it but in any case any insight will be helpful.

TIA.



Edited 1 time(s). Last edit at Wednesday, September 21, 2011 at 08:14PM by C3Po.

Valores

So you are selling a 30-40% out of the money put and collecting 1% in premium as long as it isn't exercised.

The main risk is that the underlying stock goes to 0 or thereabouts and you have to fork over a ton of cash to buy it at the "predetermined price"

It's a strategy that has made lots of people money. Most of the time, the equity curves show nice steady gains for a long time and then suddenly drop off to zero or at least some massive drawdowns.

People stay in for a while, thinking, I'm just going to do it for a little bit and then get out, but the thought of free money is just too appetizing until the giant comes back from hunting and Jack has to run away in search of the beanstalk.

Windjammer

Thanks. This makes some sense. Where does the investment firm make it's money. Only from the fee?

dyga

Well there's a management fee, of course. Then there's the possibility that you should be getting a 2% premium for that option if you sold it yourself and they're keeping the difference. Then there's also the possibility that the firm exercises your option when the price goes low, while selling the same option to someone else, thus pocketing whatever time value is left in the option and leaving you with an exercised put option as per the contract.

CFA4Techie

Well there's a management fee, of course. Then there's the possibility that you should be getting a 2% premium for that option if you sold it yourself and they're keeping the difference. Then there's also the possibility that the firm exercises your option when the price goes low, while selling the same option to someone else, thus pocketing whatever time value is left in the option and leaving you with an exercised put option as per the contract.

luda002

@bchadwick. Thanks very much.

ba736

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Edited 1 time(s). Last edit at Thursday, September 22, 2011 at 03:47AM by BangBusDriver.

cfalevel2011

Basically it's a barrier option with some sort of equity swap component fixed to it.

Do you end up owing it if it goes below 40% level or stays above 60% level?

Both trades are possible. In both the cases, they'll make money with fees, volatility, correlation and a swap with someone else if there is some sort of upfront payment which should be there. There must be a volatility criteria, this 1% they are paying is essentially coming from structuring volatility, and 1% is quite high, so there must be something to lever up the trade from your friend's end.

From their side, they'll go long the volatility, and depending on what happens at barrier.. they'll go long/short the correlation as well, they might long/short deep in the money put/call depending on what happens at barrier, and they might as well initiate a total return swap with someone else, and finally they'll keep on constantly delta hedging.

morebeans

Basically it's a barrier option with some sort of equity swap component fixed to it.

Do you end up owing it if it goes below 40% level or stays above 60% level?

Both trades are possible. In both the cases, they'll make money with fees, volatility, correlation and a swap with someone else if there is some sort of upfront payment which should be there. There must be a volatility criteria, this 1% they are paying is essentially coming from structuring volatility, and 1% is quite high, so there must be something to lever up the trade from your friend's end.

From their side, they'll go long the volatility, and depending on what happens at barrier.. they'll go long/short the correlation as well, they might long/short deep in the money put/call depending on what happens at barrier, and they might as well initiate a total return swap with someone else, and finally they'll keep on constantly delta hedging.

AnalystAlan

it should be ATM strike down and in barrier at 30-40% of current price Put option that investor sells within the structured product