Options: What Are They and How They Are Used In Structured Notes
Options are popular financial instruments that give their holders unique payoff structure. They have been traded as early as ancient Greece, when traders speculated on Olive harvest1. Today, options are commoditized contracts traded on various exchanges such as CME or NYSE.
Why Options?
Easy to buy and sell - they are one of the most popular financial instruments, used by a wide variety of retail and institutional investors.
Flexible - allowing investors to express a wide variety of market views, tailored to their time horizon and investment goals.
Many use cases - hedge an existing portfolio position, used as insurance against an undesirable event, or provide leverage exposure to an asset
What Are Options?2
They are derivative financial instruments - i.e., their value is derived from an underlying asset such as a stock.
They give the buyer a right (not obligation) to buy or sell an asset at a specific price (strike price) in the future. 3 The right to buy an asset is called a Call Option, and the right to sell an asset is called a Put Option.
Buyer would almost always4 pay a premium to the seller to buy an option.
You can trade an option, usually through a brokerage account, by buying or selling it.
Each option has a fixed maturity date such as October 5, 2023.
Options have a strike price. The strike price is the price at which the buyer of a call (put) option can buy (sell) the asset to the seller of the option contract.5
How are Options Used in Structured Notes?6
Options are typically a component of a structured note in order to give the note holder a guaranteed payout structure upfront.
In general, to create a structured note, option(s) is(are) either sold to generate a volatility-based yield of an asset, or is(are) bought to provide a directional exposure to an asset.
For principal protected notes, one or a combination of options are bought in order to give the note holder participation in the price movement of an underlying asset while maintaining principal protection for the note holder.
For yield enhancement notes, either call or put options are sold in order to give the note holder a volatility-based yield of the underlying asset. The risk to the noteholder is that if the price of the asset exceeds the strike price, which triggers the exercise of the option, the noteholder may take on losses. However, the beauty of a structured note is that the risk and payoff of a note is guaranteed up front so there is no surprise to the noteholder.
Conclusion
Options are versatile financial instruments that offer both retail and institutional investors a range of strategic possibilities, from hedging risk to amplifying returns. Their adaptability also extends to the realm of structured notes, where they serve to predefine risk and reward for investors. Whether you're looking to protect your principal or enhance yield, options can be tailored to meet diverse financial goals. However, understanding their complexities is crucial for maximizing their potential. In summary, options are indispensable tools in modern finance, offering unparalleled flexibility and strategic depth.
Remember that none of the information presented in this letter or on the blog constitutes investment advice or solicitation of any kind. Fig Investments is not currently offering any investment products. Before investing money in any asset or investment product, you should conduct your independent due diligence. Please refer to Fig Investments' disclosures here.
https://www.businessinsider.com/the-story-of-the-first-ever-options-trade-in-recorded-history-2012-3
For this post, we will be focusing on American Style vanilla options. There are various classes of options with different styles of “exercising” the option - how the buyer elect to get the payout, such as European or Asian options, or different ways the payout is calculated, such as exotic options.
Hence the name “option”. The buyer always has the option to buy or sell something, but doesn’t have to.
“Almost always” - unless an asset price trades negative, like WTI oil did in June 2020: https://www.cnbc.com/2020/06/16/how-negative-oil-prices-revealed-the-dangers-of-futures-trading.html
Most of the option contracts are traded through exchanges, and are cleared through a clearing house such as the Option Clearing Corporation (OCC) (https://www.theocc.com/). This just means you don’t have to manually find a seller and making sure they are good for paying you out for the option contract - the clearing house would guarantee all the option contracts will settle.
For an excellent categorization of the various types of structured products, please check out the Swiss Structured Products Association Website: https://sspa.ch/en/products/