You can see structured derivatives as products created by mixing different derivatives and securities to achieve customized outcomes. Often in this mix two options on the same underlying asset but different maturity dates, different types (call, put) and/or different strike prices can be found.
A structured derivative product can also be created by mixing options and the underlying asset such as in the example of covered calls. Each parameter is used carefully to produce very specific outcomes. We will see some of the most common application in the markets today.
This article will give you a pre-exposure to some of the more articulate structured option strategies we’re about to uncover in the following articles. Mastery and preparation mean a lot when it comes to trading but particularly option trading is a very sensitive and customized field that requires traders to be on top of their game. This can be achieved by continuous practice and review of high-quality material out there and in this article.
Mixing options with underlying securities
You can also create different outcomes by creating a portfolio consisted of an option combined with its underlying security. Covered calls are great examples that are commonly utilized by investors and professional traders.
This technique allows us to create structured products with very specific outcomes. For instance, covered call is a strategy that’s created by a short position of a call option and a long position of its underlying security. Although shorting a call option is a very aggressive strategy by itself, owning the underlying asset permits a totally different risk/return profile that’s much less aggressive. This also allows investors to become premium collectors and almost mimic an insurance provider. Covered calls are great examples showing the vast capabilities of options and extremely diverse opportunities that option world offers. We will take a closer look at covered calls and its alternative PMCC (poor man’s covered call) in their individual posts in more detail which will help you understand the exact dynamics that make the covered calls a profitable, low-risk favourite strategy for some investors.
Another advantage of structure d products is the ability to design profit outcomes around very specific time or price brackets. These are sometimes also referred as non-directional strategies because investor profits when the underlying price stays around a certain level (slightly above or below a figure).
Butterflies are good examples to this. In the generic profit/loss chart of butterfly strategy you can see that profit is maximum somewhere in the middle at a certain value. As the underlying security’s price goes up or down profit goes down and after the breakeven points on both sides, strategy starts losing money.
In the case of butterfly strategy, it lets you create a unique profit profile. You can profit if the underlying price stays in a range and if it doesn’t your loss is still limited at a band regardless underlying price falls or increases.
By twisting the components, you can achieve even more specific outcomes. For instance, iron condor strategy has a very similar profit profile to the butterfly, but you can see that the maximum profit can be a wide range rather than a single value as in butterflies. This allows your strategy to be able to seize profits at a wider range of underlying price movements. As the iron condor profit and loss profile graph demonstrates your loss is also limited as in the butterfly example. Loss bottoms out at a certain level and doesn’t get bigger after that.
In case of the straddles and strangles you can create a strategy which allows you to profit when the underlying price goes up or down. These can still be considered as non-directional strategies because you can profit in both directions if the underlying price moves enough to offset the cost of the strategy. We will see more about straddles and strangles in the upcoming posts.
Structured products can also be used to create directional spreads. In the example of bull put strategy you can see how strategy becomes profitable as the underlying security price increases. This strategy expects to be profitable when the underlying price goes up and it’s created by using a put option spread hence the name bull put spread. You can also see from the graph that creating this spread allows us to limit the maximum loss but as usual it comes with a restriction on the profit side as well and the profit is also capped. This means after certain levels no matter how high the underlying price goes up
strategy caps the profit to a fixed value. On the other hand, no matter how low the underlying price goes your loss will be similarly limited at a certain level.
Bear call spread is a similar example to structured products. In this case call options are used to create a bear strategy and strategy becomes more profitable as the underlying price falls. Similarly, both profit and loss are limited. In the upcoming articles we will see how these strategies can be created and that makes them behave in different ways in terms of profit and loss.