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What's the right protection level? Structured Notes & Volatility

Halo always likes to remind our readers of some of the tradeoffs between different types and features of structured notes available on the platform. Here we’ll discuss the difference between Hard and Soft protection.


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Basics of Protection Types

As a reminder, both Soft and Hard Protection provide a level of downside investment protection against the underlying asset decline, the two are very different types of protections. While Advisors should also make their own conclusions on what type of protection is best suitable for their individual clients, there can be times when one type of protection looks more favorable than the other. Let's explore...

Hard Protection

Hard Protection, the more conservative of the two, offers a "buffer" against market declines. The investor begins to incur losses once the protection level is breached. For example, take a 3 year Structured Note linked to the S&P 500 with 15% Hard Protection.

If at maturity, the S&P is down anywhere between 0% and 15% on a price-level basis, the investor would receive their full principal back. The Hard Protection level has not been breached since the S&P 500, in this example, didn’t decline more than 15%. However, if the S&P 500 was down 20% over the 3 year period this structured note investor would be down 5%. In short, it's the difference between protection level and actual declines of the underlying index or asset.

Soft Protection

Conversely, Soft Protection acts like a “barrier,” meaning once the protection level is breached at maturity the investor is fully exposed to the price loss of the underlying asset. Again, let's use the 3 year Structured Note linked to the S&P 500 as an example.

Instead of having 15% Hard Protection, let's assume this Structured Note has 15% Soft Protection. If at maturity, the S&P 500 is down anywhere between 0% and 15% on a price level basis, the investor receives their principal back - just like with Hard Protection above.

However, if the S&P 500 is down 20% on a price basis at maturity, the investor is down the full 20%. This is similar to if the investor had invested in the S&P 500 outright, excluding dividends. This is a telling example of why Hard Protection is a more conservative type of protection versus Soft Protection.

Protection During Volatile Markets

Now, during times of turmoil like these, some Advisors might be thinking, "why the h*ll would anyone want Soft Protection over Hard Protection?" Well, there are a couple of reasons!

Factors in Protection/Return Levels First, the upside participation rate an investor would receive using Soft Protection is most likely significantly higher verus using Hard Protection. This is especially true during periods of high volatility. Naturally, if the investor is taking more risk on the downside by being exposed to higher potential losses, they should be compensated on the upside in the form of a higher participation rate.

Why does the investor receive a higher participation rate with Soft Protection?

The makeup of a Structured Note is a zero coupon bond and an options package. With Soft Protection, the options component consists of short binary put options and long at the money calls. Given the note issuer is selling binary puts, there is a considerable amount of premium generated that's used to buy more call options.

With Hard Protection, the option makeup consists of selling regular (cheaper) puts and buying at the money call options. As a result, there is less "cash" available with Hard Protection to buy the call options producing a lower participation rate when compared to Soft Protection.

Same Upside, Different Protection

We often get asked, what's the percentage difference in protection levels between Soft and Hard Protection that achieves the same upside participation rate? In an ordinary market, that difference can typically be 15 percentage points.

Meaning, a Structured Note with 15% Hard Protection can produce the same upside participation rate as a Structured Note with 30% Soft Protection. However, in periods of extreme volatility like we're seeing now, the difference can be even larger. As a result, Advisors may be better served to take advantage of volatility and lock in a deeper level of Soft Protection.

This leads to a second potential advantage of using Soft Protection in times of market volatility.

Soft Protection through a Structured Note allows investors to "sell volatility" at abnormally high levels. Moreover, this can be easier to implement than using options or an inverse ETF (which created perils in 2018 with XIV as you may recall).

This is one major reason I like to use Soft Protection in times like these. Structured Notes not only allows investors to lock in deep levels of protection after an already nasty sell-off, but it allows me to be opportunistic in selling volatility. It can also potentially capture high upside participation rates if/when the market rallies back.

Using Halo for Finding Protection Levels

This is one benefit of Halo; Advisors can use our pricing tool to price thousands of Notes instantly to see which Structured Notes serve their needs. Using the tool to compare results between Soft and Hard Protection is actually really fascinating.

Soft Protection leaves the investor fully exposed if the Underlying breaches the protection level. At the same upside participation level, Soft Protection can also offer the benefit of significantly more room on the downside than Hard Protection.

In my opinion, Soft Protections of 30% look very interesting right now, especially as I write this on the evening of Sunday, March 8th, and S&P 500 Futures are limit down.

Using a time period of 12/31/1986 to 03/06/2020, the S&P 500 has breached 30% on a 3 year rolling period just over 5% of the time on a price level basis. This is compared to just over 13% of the time with 15% downside protection over the same time period.

Further to this point, Advisors can use Halo's Analytics tools to help them assess the risk of many types of Structured Notes.

Keeping A Long-Term Perspective

In times like these, cooler heads need to prevail. The coronavirus is very scary to us all personally, but fear often leads to opportunity.

We are entering an election season and jobs data looks very strong. There are still monetary and fiscal policy tools available. While I don't believe we have seen the worst of the virus and its economic effects, Advisors should consider using Structured Notes to deploy cash on the sidelines as an attractive entry point.

There’s also the benefit of still having protection on the downside if the market keeps falling. If Advisors don't have cash, they should consider selling long equity exposure, harvest some losses, and use the proceeds to buy a Growth Structured Note. In both cases, it will give clients some comfort knowing their Advisors are using this downturn as an opportunity, while having the comfort of knowing there is additional downside protection in the portfolio. I know I do.

Structured Notes During Volatile Times This is one of the most opportune times to utilize Structured Notes in the portfolio. And if you don't own them already, take solace in knowing the terms look more attractive than they have since the financial crisis.

Most important, don't panic. We are all in this together, whether in a personal or investing regard. I personally stand ready to help you and your practice with ANYTHING you may need. These are indeed challenging times, but this is exactly why Halo exists.

Best regards,
Jason Barsema


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