Are you concerned about stock market declines? Finding solutions to protect from market downside is not easy. It is time to think beyond traditional stock and bond investing. A possible solution for concerned investors is dual-directional structured notes, which provide positive returns in an up-and-down market.
Let us discuss in-depth structured notes, and dual directional structured products, and their types, advantages, and disadvantages.
Structured Note
Structured notes are debt securities. It is a combination of debt and derivatives. The debt investment product comes with a fixed interest rate. A portion of the amount is invested in debt so that the invested face value is obtained on the maturity date. Derivatives include one or more underlying assets such as stocks, equity indices, options, currencies, commodities, etc.
Structured notes may be linked to one or more underlying reference assets. Structured notes have built-in full principal protection, and a level of downside protection and also come with upside potential. Since structured notes, include both bonds and derivatives, it allows the investor to participate in the upside return with limited risk.
The returns are based on the underlying asset price and the terms of the structured note. The returns are made in lumpsum at maturity or in the form of coupon payments at specified periods.
Structured notes offer customization based on the risk-return objective of the investor. This makes it appealing to both retail and institutional investors. The structured investments are complex to understand and are not free from the credit risk of the issuer. It is better to take the advice of a financial advisor to reach your investment objectives and financial goals.
There are many types of structured notes. Dual-directional structured products are one of them. Let us learn about it in detail.
Dual Directional Structured Products
Dual-directional structured products or absolute notes or simply dual directionals (DDs) are a type of structured note that can yield positive returns if the performance of the underlying asset is positive or negative within a certain range. DDs do not have a principal back guarantee and have different embedded options positions.
DDs tend to be priced at a premium to value across issuers and underlying securities. However, if the gains or losses are not within the range, the investor’s gains are capped on the upside, and on the downside the investor can lose much or all of his investment.
DDs are embedded options called the ‘straddle’ position on the underlying security. Straddle positions are nothing but buying both at-the-money (ATM) call and at-the-money (ATM) put. An options trader with a straddle position achieves a payout that is the absolute value of the return profiting from a deviation from current levels positive or negative. Straddles do not reflect a directional bet on future price but instead are bet on volatility.
Categories of Dual-Directional Structured Products
Dual-directional structured products are further categorized into single-observation dual directionals (SODDs) and knock-out dual directionals (KODDs).
Single Observation Dual Directionals (SODDs)
SODDs payout is based on the underlying asset’s value on the final valuation date (less than 2 weeks before the maturity of the note). In some cases, SODDs may provide a buffer from downside risks, so that returns below the lower threshold are not applied to the principal investment.
SODDs combine zero-coupon bonds with at least five option positions, that are (i) long on at-the-money (ATM) puts, (ii) short asset-or-nothing (AON) puts, (iii) short out of-the-money OTM puts, (iv) long on at-the-money (ATM) call, and (v) short an out-of-the-money (OTM) call. The asset-or-nothing (AON) binary puts comprise the lower barrier and the strike price of an out-of-the-money (OTM) call sets the upper trigger. Changing the number of put options, a buffer can be included beyond the trigger level.
Knock-Out Dual Directionals (KODDs)
KODDs have a trigger feature if the underlying asset depreciates below the barrier level it removes the possibility of positive returns on the note as on the final observation date. KODDs do not offer a buffer to negative returns on the underlying asset.
KODDs combine zero-coupon bonds with the same maturity as the structured product with at least four option positions they are (i) long on at-the-money (ATM) put, (ii) short two knock-in puts, (iii) long on at-the-money (ATM)call, and (iv) short an out-of-the-money (OTM) call. The knock-in sets the lower barrier. The strike price of the OTM call sets the upper trigger. The number of call options should be increased proportionally if the DD leverages the positive returns of the underlying below the maximum return.
You can find that DDs with embedded leverage or SODD features are less worth than products without leverage or with a knock-out option.
Features of Dual-Directional Structured Products
DDs do not issue coupons and derive value from the lumpsum payout at maturity dependent on an underlying security or index.
The investors participate in the returns of the underlying asset when the asset increases in value.
DDs have a return linked to leveraged or unleveraged exposure of an underlying asset, which is subject to a cap.
Investors also get a positive return if the underlying asset decreases in value within a range, which is up to the barrier level and can also lose principal if the asset decreases in value outside of that range.
Benefits of Dual-Directional Structured Products
Diversification
Dual-directional structured products provide a unique diversification opportunity. It allows investors to benefit from both rising and falling markets. This reduces portfolio volatility and safeguards returns during market uncertainty.
Higher Returns
The bidirectional payoff structure allows investors to get higher returns compared to traditional investments. This feature is beneficial in volatile and range-specific markets.
Risk Management
Dual-directional structured products can offer a safer investment option as they are principal protected and downside hard protection and soft protection which mitigates losses while still allowing for upside participation. This balance of risk and reward is a huge advantage.
Flexibility
Dual-directional structured products can be customized to meet specific investment goals and risk tolerances. The investors can choose varying degrees of leverage, maturity periods, and underlying assets. This customization makes them suitable for a wide range of investors.
Market-Neutral Strategy
Dual-directional structured products provide a market-neutral strategy that can generate returns irrespective of market trends. It is suited for investors who are uncertain about market conditions but anticipate volatility,
Risks and Considerations
Complexity
Dual-directional structured products are complex to understand and may need more knowledge of the underlying assets. Investors must be aware of the terms and conditions, and also if there are any caps on returns and the specific calculation of payoffs.
Market Risk
Dual-directional structured products offer returns from both market directions, but they are still subject to market risk. Significant movements beyond the range can impact returns, and the capital protection feature might not cover all scenarios.
Liquidity
Dual-directional structured products cannot be sold before maturity which makes it difficult for investors to liquidate their positions before maturity. The structured note market is very limited. Some DDs can be sold in the secondary market at a considerable loss. Dual-directional structured products are mostly illiquid.
Credit Risk
These products are often issued by financial institutions where the creditworthiness of the issuer should be considered. In the event of issuer default, investors may face a loss of principal.
Cost
Dual-directional structured products are priced at a significant premium to present value across issuers compared to traditional investments. Due to the customization of the DDs, it includes fees and expenses related to structuring and managing the product. These costs can decrease the overall returns.
Comparison with Traditional Investments
Equities
Equities offer capital appreciation and dividends. They benefit only from upward movements. Dual-directional products, on the other hand, generate returns in both upward and downward markets, which is advantageous in volatile conditions.
Bonds
Bonds provide fixed-interest income and capital preservation and lack higher returns. Dual-directional products can offer higher returns. The bidirectional nature of DDs allows for higher returns in fluctuating markets.
Mutual Funds and ETFs
Mutual funds and ETFs offer diversification and professional management, and their returns are largely dependent on upward market direction. Dual-directional products offer diversification and professional management but the returns are not dependent only on the upward direction of the market.
Derivatives
Derivatives like options and futures offer bidirectional returns but often involve higher risk and complexity. Dual-directional structured products provide a more accessible and potentially safer way to achieve similar investment goals.
Market Conditions and Suitability
Volatile and Range-Bound Markets
Dual-directional structured products are particularly suited for volatile markets and range-bound markets, where frequent fluctuations within a specific range are expected. The payoff can be got in either direction.
Uncertain Market Direction
The market direction can be uncertain and volatile. Dual-directional structured products offer an advantage with their straddle options position. They provide the potential for returns without the need to predict market trends accurately.
Risk Appetite
Investors with a moderate risk appetite may find dual-directional structured products appealing, especially if they seeking high returns through market volatility. The principal protection feature can also make these products suitable for more risk-averse investors.
Conclusion
DDs are suitable for moderate-risk investors. The investor can earn returns when the underlying asset is within a range irrespective of the direction. Market volatility and market uncertainties within the range will still give you good returns. Investors should also be aware that the DDs come with an upside cap which may affect the upside returns.
Though DDs may look appealing to investors, they are complex to understand. DDs should be carefully analyzed before investing in them. It is best to consult a financial advisor before investing in DDs. A financial advisor with his knowledge and experience can analyze and value dual-directional structured products.
