DIY and Analysis: 100% Downside Protection with Upside Participation on the SPX
Cboe Guest Author: Joe Halpern, CEO, Exceed Investments
What if I offered you 100% downside protection with significant upside potential in the S&P 500 Index? Depending on your personality, you may be skeptical or excited. A good portion will believe it is too good to be true or that there is a catch, but there really is not – though there is nuance!
Not only are these types of characteristics regularly offered in vehicles like structured notes and insurance products, now there is a new self-proclaimed “first ETF” to offer just this sort of investment . This follows in the footsteps of other ETF products that have competed with buffered notes. This (structured note strategies) was a common approach used by banks, and the industry has evolved to include the strategy within variable indexed annuities, and now ETFs as well. And, like those initial buffered ETFs, this new 100% downside protection vehicle is garnering a lot of attention from both the press and investors.
I know these strategies well, having engineered these sorts of products for global banks, deconstructed them as part of the Lehman Estate, launched innovative products based on them with partners using indexes, insurance products and mutual funds, and generally been involved with them in almost every imaginable way over the last couple of decades.
Creating your own 100% downside protection with upside participation using S&P 500 options (SPX)
Here’s a little secret: If you understand the trade-offs of the strategy’s exposure, it is not too good to be true and, in fact, not overly difficult to execute on your own. However, I would recommend seeking advice from an options professional if you’re not well versed with these strategies. Let’s use a hypothetical example matching the general characteristics of the ETF offering, using prices as of the close of August 3, 2023  and deconstruct what is going on:
- 2 years to maturity
- 100% downside protection on the SPX index
- 100% upside participation on the SPX index up to a 17.25% cap
This is the range of payoffs vs simply going long the index, assuming the position is held to maturity:
 TJUL: Offering a 16.62% upside cap.
 Hypothetical pricing using delayed pricing not inclusive of any fees and other potential costs which would vary based on your access (e.g., platform, brokerage, etc.). While we equated a higher cap pricing was done on a different day then the referenced ETF and therefore there is no way to claim better or worse pricing or infer really any comparable characteristics beyond that this can be done on one’s own.
The hypothetical projections shown in the table above are intended to illustrate how the expected strategy would play out given different scenarios and are not intended to represent the performance of any Exceed Advisory portfolios or of Exceed as a firm.
As can be seen from the graph above, no losses are taken if the market is down, and the strategy participates in 100% of the upside to its cap of 17.25%.
Now let’s reconstruct the strategy ourselves.
This strategy consists of three positions:
- A long position in a two-year US Treasury Note
- A long position in a two year at-the-money (ATM) call option in SPX
- A short position in a two-year, 17.25% out-of-the-money (OTM) call option in SPX
As can be seen from the table above, investors can create this position synthetically, on their own! 
 Meaning, an investor can purchase a structured note with these exact characteristics from a bank for $100,000 as an example, or instead purchase the above components which mimic the characteristics of the structured note for ~$100,000 prior to transaction costs and any account maintenance costs which will vary based on your platform/broker.
The ease of creating alternative strategies to best fit an investor’s preference
What if we hate caps and rather simply have uncapped participation? That would consist of a grand total of two positions:
- A long position in a two-year US Treasury Note
- A long position in a percentage of two year at-the-money call options in SPX
We can purchase roughly 66% of uncapped upside for a payoff that looks like this, if held to maturity:
In bullish markets, the Participation strategy will outperform that of the Capped Strategy, and vice versa.
The hypothetical projections shown in the table above are intended to illustrate how the strategy would play out given different scenarios and are not intended to represent the performance of any Exceed Advisory portfolios or of Exceed as a firm.
The advantages of the DIY Approach
Investors’ primary choices are to select from pre-defined strategies through structured notes provided by issuing banks; variable and fixed indexed annuities issued by insurance companies; and, more recently, ETFs offered by ETF issuers. Because they’re pre-packaged, these offerings may not perfectly match the intent of the client. Further, within the bank and insurance channel, liquidity may be a concern. An investor should also exercise caution when buying into a buffered ETF or similar after issuance, as the expected exposure may be meaningfully different what was initially advertised due to market movement. While issuers tend to provide those new headline maximum downside and upside figures, they do not provide the new probabilities of these outcomes. This can really skew understanding of what the true opportunity or risk is for less-sophisticated investors.
Yet, as can be seen from the examples above, many times a strategy consists of a few, easily accessible securities that can be used to construct a custom exposure. A single option unit represents 100 shares of a security. That means when using SPX, the smallest notional size of a strategy is roughly $450,000 (spot price of SPX * 100). However, Cboe has launched a mini-SPX with identical characteristics at 1/10th the value, which would allow investors to create their own strategy for less than $50,000! An investor would potentially save on issuance costs, have daily liquidity with minimal exit costs if they chose to exit early, and could create any sort of exposure they desire within reason by using the power of options!
What investors should be aware of and methods to analyze a best approach
First, options do not capture the dividends associated with the securities that underly an index. For this reason, pay close attention to whether the index used as the benchmark is titled “Total Return” or “Price Return”. A total return index will include dividends, while a price return index won’t. When participants think of the market generally returning 8% annually, part of that return is dividend distributions.
More important though, is that these strategies always look compelling. After all, in the stated strategy an investor has no downside risk yet is receiving returns. That return profile, though, needs to be understood in the context of other opportunities in the market to really understand what you’re getting.
For example, if an investor simply purchases the treasury portion of the strategy, at prices shown in the illustration they are generating a guaranteed return of approximately 10%  over two years with no downside (assuming you believe there is no chance of a government default) as long as it is held to maturity. Meanwhile, an investor should assess the probabilities to be assigned to the various outcomes between 0% and 17.25% in the capped strategy to truly understand the opportunity. If the market is down at the end of the two-year term, an investor in the note strategy would receive 0% while an investor in a treasury note alone would receive 10%.
 The yield over the two-year period is actually 10.1% as one is making a $908.24 investment and receiving $1,000 back. $91.76 / 908.24 = 10.1%
The hypothetical projections shown in the table above are intended to illustrate how the strategy would play out given different scenarios and are not intended to represent the performance of any Exceed Advisory portfolio or of Exceed as a firm.
Ultimately though, the real benefits of using options include (1) the flexibility to construct a truly customized exposure based on your holdings, and (2) to generally take advantage of options in further diversifying streams of income (for example, premiums from covered calls, whether overlayed on models or single positions), provide risk mitigation, and even optimize tax liabilities for concentrated positions, among other opportunities. Simply put, for many advisors not incorporating options into your practice is a mistake given the unique benefits they can provide.
For example, perhaps the right approach is to use high yield (HY) as the underlier for a DIY structured note approach. High yield is considered equity-like, so you can achieve a purer form of exposure with materially enhanced yield that now allows a participant to capture 125% of the upside. However, this does pose a higher risk to the downside protection via potential defaults in your high-yield exposure (which one may capture from bullet ETFs  providing the appropriate diversification and selection).
 “Bullet” ETFs are a subset of ETF fixed income offerings where there is a maturity date for the ETF. This allows an investor to buy an exposure to a certain maturity rather than a rolling exposure. For example, buying a High Yield bullet ETF maturing in 2026 will have a diversified exposure to high yield securities that all mature in 2026 as compared to a traditional high yield ETF which will have a constant maturity.
In summary, these strategies are rather simple to build on your own, though a specialist may add value in providing a complete analysis, in constructing an optimal approach, managing execution, and providing ongoing oversight.
Exceed Advisory (“Exceed”) selectively partners with large RIAs and Family Offices in optimizing their option use through initiatives like tax harvesting for concentrated positions, providing customized covered call programs on proprietary models and general guidance on all things options. Option strategies are fully customizable and can be tailored to the specific needs of each individual client. The Portfolio Management Team at Exceed collectively has over 40 years of professional derivates experience and can help to seamlessly pass the benefits of options along to advisory practices and their clients.
Check out our site and set up a call with one of our team members to learn more.
About the Author
Joe Halpern has a 25+ year career primarily focused on options having been a specialist on the AMEX, a director on the global capital markets desk with ING focused on exotic options, a director at the Lehman Estate tasked with unwinding a significant commodity-based portfolio, part of a task force in unwinding structured notes and a leading negotiator with a number of big banks. Currently he leads Exceed (note above) and provides expert advice on options to government and commercial entities in addition to being a Chief Investor Officer at Fountainhead, an outsourced Chief Investment Office. If you have questions, reach out at [email protected]
IMPORTANT DISCLOSURE: The information in this blog is intended to be educational and does not constitute investment advice. Exceed offers investment advice only after entering into an advisory agreement and only after obtaining detailed information about the client’s individual needs and objectives. No strategy can prevent all losses or guarantee positive returns. Transaction costs and advisory fees apply to all solutions implemented through Exceed. References to TJUL and related mathematical illustrations are provided for educational purposes. Our discussion of TJUL is not an offer to sell, a solicitation of an offer to buy, or a recommendation of any security or any other product.