DIY Equity-Linked Notes

Over the years, I occasionally run into equity-linked notes (ELNs), financial products that are often sold as providing access to some of the potential upside from stocks and guaranteed protection of principal (there are many variations of ELNs). Most recently, I read a super-enthusiastic sales pitch on these products in Tony Robbins’ book, MONEY: Master The Game. Robbins repeatedly refers to these products as ‘engineered safety‘ — who wouldn’t want some of that? The devil, as always, is in the details. There is nothing inherently wrong with this concept, a variation on which has been espoused by Zvi Bodie, a well-known finance professor, for many years. The problem in practice is the fees and complexity associated with ELN offerings. And, of course, any sensible person should realize that there is no free lunch here.

With modern financial technology, an individual investor or advisor can construct this type of strategy very cheaply. You buy a bond or CD with the majority of your money and then buy call options on the stock index of your choice (using an ETF is the easiest), using the promised yield on the CD to pay for the call options. Looking at how to replicate an ELN shows what is actually possible and the trade offs.

As of this writing (December 2019), you can buy a one-year CD with a yield of 2%. If you are willing to use the expected income from this CD to purchase some upside exposure in the stock market (S&P 500, for this example), what would that look like? Today, SPY (an S&P 500 ETF) is trading at $321.18. You can buy a one-year call option (expiring on Dec 18, 2020) with a strike price of $321 for $20.57. Owning this option gives you all of the price appreciation in the S&P 500 over the next year if the price goes up, but you have no exposure if the price drops. On December 18, 2018, the option expires. Options with strike prices at (or very near) the current price of a security are referred to as being at-the-money (ATM).

Source: eTrade, December 20, 2019

So, you can buy a share of SPY and own the S&P 500 for $321.18. Alternatively, you could use this money to buy a CD with a 2% yield and be guaranteed to earn $6.42 over the next year. With that $6.42 you could purchase 0.3 ATM call options on SPY. In other words, the interest on the CD can buy you partial exposure to the gains of the S&P 500. Of course, in real life, you can’t buy fractional shares in options, so let’s make this more realistic and say that you have $3,218 (enough to buy 10 shares of SPY). You can either buy 10 shares of SPY or you can buy three ATM December 2018 call options on SPY for a total of $61.71 and then invest the rest ($3,156) in a 2% one-year CD (which will pay out $63.12 in yield).

So, we have two scenarios with which to invest $3,218:

  1. Buy 10 shares of SPY
  2. Buy a 12-month CD for $3,156 and buy three call Dec 2018 ATM call options

If the market has a price appreciation of 30% (similar to 2019), strategy 2 would have a return of 9%. If the market had a negative price return, you would end up with the $3,156 you invested in the CD, plus $63.12 in interest. You get 30% of the S&P 500’s price gains and you are guaranteed to get back at least your principal at the end of the year. In a year like 2016, when the total return of the S&P 500 with dividends was 12%, you going to end up only slightly better-off than you would have with the CD alone. Note that you don’t get any portion of the dividend income associated with the underlying investment (the S&P 500 in this case.)

There are many variations on the DIY equity-linked note. If you are willing to take some modest amount of loss, you can get more upside (buy 4 call options instead of 3, etc.). Implementing this strategy requires only two transactions a year–buy a CD and buy a 12-month call option.

I have shown a single snapshot of creating a strategy that mimics an ELN. Over time, there are multiple variables that will change. The yield on a CD varies over time and is currently very low by historical standards. The price of the call options on the S&P 500 (or whatever underlying security is used) is currently quite low because market volatility is low.