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Build A Structured Product In Real Time

Many of you may have heard about so-called structured products, which are usually sold by banks to clients with a decent of capital (sometimes, only to sophisticated/accredited investors only). The idea behind a structured product is simple: it provides a nice expected return with a small (sometimes, zero) risk. This asymmetric risk-return profile is achieved using the mix of stock options and bonds (or like low-risk instruments):


Although structured products are a not a panacea, especially for long investment horizons (as debt instruments tend to underperform equities on the long-run), they are ideal for relatively short-term investments (up to three years or so) or for timed portfolios (i.e. portfolios with specific "exit dates"). For example, if you are saving for a downpayment for a house or a car (i.e. a big purchase), investing in equities is simply not an option - you have no idea where the stock market may end up, especially given the wide volatility it has exhibited over the past few years. On the other hand, savings accounts or even certain marketable debt instruments (i.e. Treasuries), barely keep up with inflation. Besides, if the stock market does indeed rally over the next several years, you will miss out on the opportunity. Hence, what you want is some sort of guaranteed return with an option for upside exposure. This is exactly what structured products do. Fortunately, I will show you a way to build a structured product by yourself without a large investment or a special status. All you need is a basic knowledge of equity options and a broker than lets you freely buy and sell options.

Selecting the "fixed" part of the structured product

The "fixed" part of the structured product is a part that will bring you a guaranteed return with little or no volatility around itself. An ideal instrument for this is some sort of short-term bond that will mature at the exact time when you need to liquidate your portfolio. For this example, however, I will take the iShares Barclays 20+ Year Treasury Bond ETF (TLT). While this instrument is not exactly a bond but, rather, an equity-like instrument with exposure to a diversified portfolio of debt instruments, it is the most readily accessible instrument for all investors reading this text. The reason is simple - it trades like a stock, and you can purchase and dispose it any time you want. Of course, there is a certain cost associated with that - because it is a market instrument, it is exposed to market volatility, which may be substantial, as we will see later.

The best part about this instrument is that it is negatively correlated with the stock market (at least in the short-term):

(Source: Google Finance)

Over the...