Consider FLEX® Options in Place of Structured Notes

This is Matt McFarland’s first contribution to The CBOE Community. He will be contributing additional pieces in the near future. His e-mail address is at the end of the article. Enjoy!

Structured notes continue to be popular among retail investors. At its most basic, a structured note is a zero-coupon bond of the issuer + a package of options. These notes provide investors with simple access to optionality, but that simplicity typically comes at a cost. Specifically, the notes lack transparency as the bond and the package of options are comingled into a single price, preventing the investor from knowing either the rate at which they are being paid on the bond or the price they are paying / receiving for the package of options.

This blog entry will look at a popular type of structured note and show how it can be replicated in a completely transparent manner through the use of CBOE FLEX® options. (CBOE FLEX options are customizable options that allow you to define your own strike price, expiration date, and exercise style; see

A common structured product is a note linked to a broad-based equity index that provides a cushion on the downside and the opportunity for enhanced returns on the upside. The upside is typically capped and the duration of these notes tend to be 1-2 years. Most of the major global banks issue these notes in one form or another.

One such note is coming out at the end of this month on the Russell 2000® Index. The note has an 18-month duration with a 10% “buffer”, meaning that the investor will not gain or lose any principal if the return on the Russell 2000 over the next 18 months is between 0% to negative 10%. If the index falls more than 10%, the note holder will begin to lose principal (i.e. these are not principal protected securities – exposure to the downside exits). If the index rises, returns are “enhanced” 1.5 times, but they are capped at 18%. For instance if the Russell 2000 returns 10%, the investor would earn 15%. The payoff of the note, as it compares to the index itself, looks like this:


1.5x upside return, capped at 18%


This payoff can be easily replicated with the use of CBOE FLEX options. In order to do so, one would conduct the following trades with IWM (i.e. the iShares® Russell 2000 Index ETF) as the underlying stock:

  • Buy 3 IWM 100% struck European-style call options expiring on November 30, 2012
  • Sell 3 IWM 112% struck European-style call options expiring on November 30, 2012
  • Sell 2 IWM 90% struck European-style put options expiring on November 30, 2012

Note that CBOE FLEX options strikes can be expressed in % terms. Using IWM’s closing price of $82.29 from Monday, your strikes in $ terms would be $82.29, $92.16, and $74.06, respectively.

Using interpolated implied volatilities from standard IWM options, we can estimate the value of each FLEX option within this structure; these prices should be considered as indicative only (the prices at which trades can actually be executed could be better or worse):

  • 100% call = $10.00
  • 112% call = $5.00
  • 90% put = $8.00

The entire package results in a net credit of $1.00:

Premium per option

Number of contracts

Total debit / credit

100% call



$30 debit

112% call



$15 credit

90% put



$16 credit

$1 credit

The amount of capital required to put 1 unit (long 3 call spreads vs. short 2 puts) of this trade on is $16,312 (if executed in a cash securities account). This is derived by:


  • taking the put strike price ($74.06) and multiplying it by the # of shares (200) = $14,812
  • then adding the cost of the 3 call spreads ($1,500)


Returns on this amount invested at expiration are as follows:


IWM Return

payoff on long 3 100% calls

payoff on short 3 112% calls

payoff on short 2 90% puts


Replicated Structure Return














































































The payoff profile of this IWM FLEX options package, as compared to being long IWM shares, looks just like the structured note:


1.5x upside return, capped at 18%

Although the payoff profiles of the structured product and its replication are virtually indistinguishable, there are some key differences that investors need to be aware of:

  • Investors in the structured product are unsecured debt holders of the issuing bank and therefore are exposed to counterparty risk. The replicated portfolio contains options issued by the AAA-rated Options Clearing Corporation, thereby virtually eliminating counterparty risk.
  • Each individual leg of the replicated options package is completely transparent throughout the life of the contracts. The structured product itself lacks such clarity.
  • Investors in the replicated portfolio have the luxury of multiple liquidity providers upon entering and exiting the trades. Structured note liquidity is usually limited to the issuing bank only.
  • The replicated portfolio results in an immediate credit to your securities account. That credit is typically not realized until maturity on the note itself. Moreover, the amount of that credit that is attributable to the options package within the structured product is not easily decipherable.
  • The replicated portfolio contains flexibility. For instance, a larger or smaller downside buffer can be achieved by changing the put strike price. Investors in the actual structured note are limited to the terms decided upon by the issuer.

I’ve focused exclusively on the options package within this structured product. But recall that the note contains both a zero-coupon bond + a package of options. Interest rates are extremely low, rendering the bond component almost insignificant. For instance, an 18-month zero-coupon Treasury STRIP currently yields just 0.31%. Nevertheless, investors in structured notes should be aware that they should be compensated at some rate above this 0.31% risk-free rate for taking on the credit risk of the issuing bank. Again, what that rate actually is cannot be determined since it is comingled with the options structure; structured note investors are essentially loaning funds to the bank without knowledge of what rate they are being paid for loaning those funds.

Several benefits of the replicated portfolio have been highlighted, but it is not without its drawbacks. Notably, investors in the note itself tend to be able to invest in smaller size; Exchange-traded options are unable to be divided up into fractional contracts, so the 3×2 that I demonstrated is the smallest increment possible on this particular structure. Moreover, investors need to do some work to put the replicated structure together themselves, as opposed to having it pre-assembled by the issuing bank. Nevertheless, the benefits of replicating appear to outweigh the simplicity of investing in the note itself.