How are options used to structure a capital protected product?

First things first, what is an option? If you’re not quite sure, feel free to check out our previous blog post where we explain everything!

Let’s say you think that the value of an index, like the FTSE MIB or S&P 500, or a group of shares will increase over time so you want to invest so that you can benefit from this increase. However if you are concerned about losing the money invested, then one of the options is a protected capital investment product.

These products, at a defined maturity date, guarantee that you will get back 100% of your investment, plus an upside if the underlyings have had a positive performance, increasing in value.

How are they structured?

Imagine you want to invest €10,000 and hold the investment for 5 years. If the index you selected returns 20% at the end of the 5 years, you would sell for €12,000 and make a €2,000 profit. However, if the market loses 20%, at the end of the 5 years you would have to sell at €8,000 making €2,000 loss.

In order to get protection on your investment in case the index loses value, you can choose to invest the €10,000 in a different way.

95% of your capital can be allocated to buy a bond. If you buy €9,500 worth of a bond, which gives you 2.02% a year, in 5 years with annual compounding you will get back exactly €10,500. The remaining €500 can then be used to buy a call option. This cost is called the premium, which is the percentage which you pay the option, based on the contact’s value.

Let’s fast forward 5 years, where you are getting back €10,500 from the bond. Let’s also say that the index is having a positive performance of 20%. The call option gives you the right to buy the index at €10,000 when the price now is €12,000. You will thus make a profit of €12,000-10,000 = €2,000 if you resell it on the market straight away.

Your total position is €10,500 + €2,000 - €500 = €12,000. Exactly the same as if you would have bought the index directly but with less risk.

On the other hand, if the index loses 20% and is now at €8,000. You will still take €10,500 + €0 - €500 = €10,000 as you will decide not to exercise the option.

Pricing options are quite complicated even if their mechanism is quite simple. You bought the option for €500 in the example above, but every day until the maturity date this number will fluctuate depending on two factors.

  1. Intrinsic value: this is the measure of how profitable the option is based on the difference between the current price of the underlying and the strike price of the option, which is the agreed price you will buy it for. In the example above, at maturity the option would give you €2000 if the underlying was up 20%, and would give you €0 if the underlying was down 20%. If the market goes up, the intrinsic value of a call option increases and if the market goes down it decreases but not exactly linearly to the actual underlying because it is not the only factor.
  2. Time value: this is a measure of how much uncertainty there is in the price of the underlying. It is easier to predict what the price of the underlying will be tomorrow compared to what it will be in 5 years. This is because of volatility, fluctuations in the value of the underlying. The time value is more significant at the beginning of the life of the option and decreases as the option nears its maturity date.

Initially time value will have a greater impact on the price of the option, as there is a larger uncertainty at the start. As time passes, the intrinsic value will have a greater impact on the price of the option and you will see the price of capital protected products continue to reflect more closely the performance of the underlying.

Capital protected products will always have these variables:

  1. A protection at maturity - it can be 100% of initial capital but also 90% or, in the case of Take Care, 105%. This amount is guaranteed no matter what happens to the underlying.
  2. An underlying - it can be an index, a basket of shares, a commodity or anything else on which you can price an option contract.
  3. A maturity - The exact number of years when you get the full guarantee and upside.
  4. An upside - It will promise a % of the upside of the underlying only at maturity. This can take different forms. For Oval products we have had different models:
    - Italian Dream: 100% of FTSE MIB performance; FTSE MIB is up 20%, you get 20% return.
    - Born in the USA: 66% of S&P 500 performance; S&P 500 is up 30%, you get ~20% return.
    - Take Care: 100% of the performance of the worst of the three underlyings.
    Let's say GSK is up 22%, Roche up 25% and Sanofi 20%, you get 20% return

Your capital is at risk and past performance may not be a real indicator of future results. Oval Money is not authorized to provide financial advice, expert advice is recommended if you have further questions.

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