Example Of How A Structured Note Works: Trying To Make Money On Apple Stock

PapayaIn CD Investment Alternatives, I touch upon structured notes as a potential CD replacement. Structured notes are riskier than CDs given CDs have a $250,000 FDIC guarantee per individual. That said, it looks like there is some interest in structured notes based upon the comments.

Let me first clear any misunderstanding that you need to be really wealthy to buy structured notes. Your private wealth manager will probably want you to come with $100,000 in investable assets, but $50,000 or even $25,000 will do if they see potential for a long term relationship. Most of the mega banks like Citibank, Bank of America, Wells Fargo, and Chase have someone in a branch who can open an account for you. My account has a running cost of $50 a year with unlimited trades so it’s not expensive at all.

Given Apple stock missed the quarter and is now down more than ~35% from its peak, I can’t think of a more interesting structured note example to educate investors who wish to understand more about derivative investing. I’ll run you through my own example to explain how it’s possible to make money with Apple as the stock collapses.

APPLE SINGLE OBSERVATION EQUITY LINKED SECURITIES (ELKS)

On December 17, 2012, I decided to buy $40,000 worth of Apple ELKS instead of lock it up in a 2% yielding CD for 7 years. Apple was already down about $200 points from its $708 high and I felt the risk reward was to the upside at 12X earnings. With the stock now at ~$440, this trade has proven to be mistimed, or has it?

When a stock is on a downward trend, the chances of an investor picking the exact bottom is slim. It’s a fools game really. If you are a value investor with a long enough time horizon, you set a valuation level which is deemed attractive and start legging in. I had no delusion of being able to pick the bottom at the time of purchase. My sole goal was to beat a 2% yielding CD in a relatively safe way without having to tie up my money for a long period of time.

Terms of the Apple Structured Note:

Apple Structured Note

Coupon: The coupon ended up being 3.5% for the six month note (7% annualized). The 3.5% coupon is paid out equally over six months e.g. 0.583% coupon a month.

Duration: Six months from pricing date = June 17, 2013 when I can reinvest the proceeds elsewhere.

Protection Threshold: 20% downside protection to receive 100% of principal investment back. At a $510 strike, 20% downside equals $408. So long as Apple is above $408 on the maturity date of June 17, 2013, I will get all $40,000 invested back. If Apple closes below $408, I will get back exactly how much the stock is down from strike e.g. stock -50%, my principal upon maturity is cut in half.

Upside: A 3.5% six month return in exchange for 20% downside protection.

PRICING SCENARIOS FOR AN APPLE STRUCTURED NOTE

Apple Structured Notes Pricing Examples

Coupon payment: As you can see from the chart, the investor will get a 3% coupon payment over 6 months no matter the performance of Apple’s share price.

Principal received upon maturity: The downside threshold in this example is $472. If the Apple unfortunately closes at $471.94 at maturity, you do not get 100% of your principal back. If Apple closes exactly at $472 or above, you do get 100% of your principal back.

* The underwriters at the time were using $590 as an example to write up the prospectus. By the time I got the prospectus, the stock had already fallen to the $500-$520 range. Examples in a prospectus give a savvy investor some edge into how a particular offering is structured. 

INVESTMENT THOUGHT PROCESS

With the investment framework laid out, I’d like you to think for a moment how you should think about Apple stock before I mention my own thoughts. OK, done? Let me share with you what I was thinking back in December, 2012.

* I like Apple because it trades at a reasonable 12X multiple / 8X ex-cash with 15-20% growth, has more than $130 billion in cash, and has a proven track record for innovation and execution.

* Despite my interest in Apple, the stock is in a downtrend and I cannot pick the inflection point.

* I’m looking to find a higher return on my money market and CD investments that yield at most 2.1% for a seven year lock up period.

* I did not think after a 28% fall from its $708 high that Apple would fall another 20%.

* Even if Apple does breach $408 sometime during the 6 month note, I believe investors will get back into Apple and drive the price above $408 by June 17, 2013 given anything less puts the stock on less than 10X lowered earnings. We should see a flurry of value and growth investors step back in.

* If Apple closes higher than my $510 strike price, say $600, I’ll actually be kicking myself for not buying Apple stock outright.

* The ideal scenario is Apple closing at maturity down 20% to $408, and no worse. The structured note saves me from a 20% loss and provides me a 3.5% coupon instead for a 23.5% swing.

SINGLE STOCK STRUCTURED NOTES ARE NOT FOR THE FAINT OF HEART

With Apple down 12% post disappointing quarterly results, I’ve only got a 8.5% barrier left to $408. Does this worry me? Absolutely. But, as I wrote in my last bullet point above, the ideal scenario is if Apple lingers -20% to flat from strike price. Worst case Apple stock goes to $0 and I collect a 3.5% coupon on $40,000 for a total loss of $38,600. With over $130/share in cash, -70% is the realistic lowest Apple can tank from here.

Buying a structured note on a single stock, especially a tech stock is much more volatile than buying structured notes on major indices such as the Dow Jones or S&P 500. This is where the large majority of my structured investments lie.

I hope you’ve found this example useful in explaining how a single stock structured note works. Now it’s time for everybody to go buy several iPhones, iPads, and $1,799 13″ Macbook Pros to help ensure Apple doesn’t close below $408 by June 17, 2013! All the kids who hardly make anything are buying the latest gadgets, so should you.

About the Author: Sam began investing his own money ever since he first opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college on Wall Street. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 35 largely due to his investments that now generate over six figures a year in passive income. Sam now spends his time playing tennis, spending time with family, and writing online to help others achieve financial freedom.
Regards,

Sam


Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    Intriguing! 25k minimum is a good chunk of change but still feasible. I’m not sure I’d be brave enough to put that much into a single stock structured product though. I’d probably opt for something on the performance of an index or etf. Maybe if you become a long term client with your bank they will start waiving that $50 fee too.

    • says

      I don’t think I’m brave enough to put 25k or 50k into a single stock either. I would probably go with one of the index as well.
      Sam, Thanks for writing this up. It’s very useful. I’ll talk to my bank once I convinced the missus to invest some of our liquidity. Probably early 2014.

  2. says

    Awesome post. I’ve seen you mention structured notes a few times before and always wondered exactly how they worked. However I would say that needed 25-50k to get in on one specific investment means that you have to be pretty wealthy to partake, no? They do seem like a pretty intriguing option if you have the money though.

    As for Apple, the recent slide has got me pretty excited about the stock. It’s amazing how a company can post the 2nd most profitable quarter ever and have its stock drop 12%! I think they’re a victim of their own success at this point & the stock will continue to slide for a while just based on the sentiment that the hyper growth days are over for them. I think if it hits $425 and starts sliding I’ll be a buyer…that mountain of cash they have just can’t be ignored.

    • says

      Not sure. Everything is relative when it comes to wealth. Depends on your savings rate, age, income and so forth. I would save for someone in their mid-to-late 30’s having $100,000 in after tax liquidity to invest in the market is pretty standard.

      What I’d like to encourage every reader to do is explain WHY they believe so and so target level, in your case $425 makes sense. That’s the way we can learn more about investing.

  3. says

    I would be very cautious with a product like this. I’m sure Citibank, the largest bank in the world, knows a little more than me about Apple, the most popular and biggest stock in the world right now (maybe not for long – it just went below Exxon’s market cap!).

    But for what my opinion is worth (a lot less than Citibank’s $130B market cap) a true value investor should be looking at RIM and not Apple. RIM was where Apple is now a few years ago and then it played out the familiar tech story. Can Apple keep going up? It’s possible but they will start running into limits everywhere since they are already so large. The latest reports show that they keep investing in R&D but the resulting products are less profitable than they were in the past so they can’t grow earnings.

    A 28% drop from the high is a lot so Apple may bounce back. On the other hand RIM dropped 96% from the peak to the bottom so there is a long way to go and they could burn a lot of cash on futile marketing and R&D to help push the price down. If Apple has saturated the market already this won’t be pretty. A healthy P/E doesn’t help much when the E falls apart. There is very little room to grow for Apple and it will come at an ever-increasing cost. If Apple only takes another 5% of the market, investors will trash it. If RIM takes another 5% of the market, its stock price will double.

    Back in September I suggested a simple long/short trade to capitalize on this. While it had a small chance of a loss, you could have put up $170 and earned $16,205.92 in two months. See here for details: valueindexer.wordpress.com/2012/11/24/im-a-great-stock-picker-with-76117945311128-returns/. It might still be worth considering but a lot of profit has already been made on that trade so it’s not as good now.

    Or sometimes simple is good. If you were choosing between buying Apple or the S&P 500 2 months ago, the right choice would net you a 33.4% difference.

    • says

      A $16,205.92 return is fantastic. What do you plan to do with the proceeds?

      I’m using Apple as an example to explain how a structure note works. And because I write about what I invest, it helps make the explanation that much clearer.

  4. says

    Sam, I see Apple going down another 50 dollars or so and then shooting back up. I understand how individual stock shares work when being purchased – what are the main differences with a structured note – is it like buying a share of stock, but with some extra policy or insurance behind it? And my apologies if I missed where you explained that.

    • says

      Hi Jeremy, would love to know why you think Apple is going down another $50 a share. It doesn’t matter so much if you are wrong or right. What I’d love to encourage from readers is to provide some plausible explanations as to why they think the way they do to improve our fundamental investing prowess.

      Structured notes are not traded. They are a derivative product issued by a financial institution which promises you the conditions stated in the prospectus come maturity. They can be sold in the secondary market, but at a deep discount, so holders need to make sure they hold to maturity.

      • Jeremy Johnson says

        Thanks for the explanation Sam. I think Apple is going down roughly another $50.00 only because at that price it is at end of year 2011/start of 2012 levels, which I believe is a more accurate value of the company based on its growth patterns. Apple rose too quickly in the first quarter of 2012 and then plunged. And it happened again in the last part of 2012. I believe now, many people are taking profit’s and the bottom is at about $400. At that point, people will get greedy again as the price is back at end of year 2011 levels.

        This is all my prediction based on patterns I see as I don’t have a strong background in the technical fundamentals of stocks, just on the patterns they follow. Of course I could be wrong and then I’d have a new lesson learned :)

        • says

          Thanks Jeremy. What I encourage you to do is to base your predictions on investing by understanding the numbers. At the end of the day, investing is all about profitability and expectations over the long run.

  5. says

    That was a great explanation, Sam.

    You are a far braver man than I to wrap that much money into one stock. I can definitely understand your reasoning, but I guess I’m just much less bullish on Apple than you. I never understood how a company that sells overpriced electronics to yuppies should be worth more than one that sells the very lifeblood of modern civilization.

    I kind of agree with you that Apple will probably close over $408 in June, but I’m a long-term investor, not a short-term one, so I don’t put much faith in my ability to make good judgements over the short term.

    • says

      It depends on what $40K is as a percentage of an overall portfolio. If it’s 10% or less, it’s not so brave imo.

      I’m hoping $408 is a barrier b/c after analysts (who are always behind the curve) have downgraded their estimates, the average EPS is around $40.50 or so. In other words, anything under $408 puts Apple below 10X earnings, including cash. That’s the level where I think value funds step in, in size.

  6. kartik says

    How does this compare to covered calls? I am thinking that the bank is basically doing this behind the scenes making 1-2% off your money.

  7. says

    Sam,

    What happens if AAPL decides to do a special dividend and distributes 100B of their cash back to investors? Normally you’d expect a similar decline in market cap, or about 20% lower. I didn’t see anything about dividends in your note above.

    • says

      That would be really neat to see a $100 billion dollar special dividend. But, we know that’s not going to happen. Stocks generally correct by amount of dividend payout for a brief period of time before normalizing back to presume another series of dividend payments.

      Good hypothetical question to consider though.

  8. says

    Whoa, the buffer works a lot differently than I thought it did. I thought the buffer was fixed so that if..say, Apple falls 25%, you’d only lose 5% less 3.5% they pay you, not 21.5%. That’s a pretty big difference in risk profile. When I looked at this in December the OTM puts 6 months out offered roughly the same 3.5% return with a better buffer in that the losses worked differently. For people who want the same trade in smaller amounts, selling puts works, too.

    Anyone wanting to follow this trade with less money and less risk can get a great deal now. The $410 puts expiring on June 22 have a bid at $18.85, for a 4.5% return. Double down, Sam?

    I’d be willing to wager it will work out fine. I agree that value managers willing to buy tech will step in soon. Looks like there’s a style shift here with growth funds dumping and value funds not yet coming in. I’m not the standard for value investors, but Apple’s financials look a lot like the kind I drool over when I find them. Compare it to MSFT, which trades at a much higher multiple of earnings, and has a history of stupid acquisitions. If I were a fund manager wanting tech exposure, it’d be hard not to see AAPL as the best quantitative value.

    • says

      It’s easy to look back in hindsight regarding evaluating a risk return profile. One can simply get this month’s Apple ELKS for a 20% downside buffer from $440 for a likely 3% gain over six months.

      I like to throw my occasional investment out there for educational purposes, just like my predictions. Nowhere to hide if I make or lose money.

  9. Dan23 says

    I asked on your cd post but you missed answering this part of my question. Do you pay ordinary income tax on the gains even if it is a greater than 1 year maturity structured note? I believe you do (at least if there is downside protection) but am not sure. Can you provide the details on structured notes and taxes. Thanks.

  10. Mike Hunt says

    Sam,

    Why don’t you just sell a naked PUT on AAPL? This way if the stock price goes below your threshold you effectively get AAPL at the lower price and if not trigger you gain the price of the put? Also you can close out the put by re-purchasing anytime instead of waiting for the 6 month lockup.

    It seems like you are paying a middle man who is pocketing some of your spread while incurring additional risk like the lockup for 6 months plus the small but possible risk the institution goes bankrupt and you lose 100% of the investment.

    -Mike

  11. says

    Sam, it is a very interesting pick you made, especially with AAPL having so many crazy swings. I will admit, I am long Apple and I do have a fairly large position for it in my portfolio. How come you didn’t buy equities, why did you go with a structured note? With a long term perspective and as bullish to Apple as you sound, why not buy and hold? Maybe I’m missing something (although your explanation was rather detailed), I just don’t see the appeal.

  12. says

    Great post and thanks for the explanation. You asked our views on Apple, so here goes:

    The price of every stock, as you know, has two components, as shown in the PE ratio (Price/Earnings). If earnings (E) go up, the price will go up. That’s the rational component. The actual P/E ratio is the emotional component that gets loaded onto the E, because it reflects investors’ expectation of growth. A growth stock normally commands a high PE ratio, while stocks with low growth expectations carry lower PE multiples.

    Here’s the dread behind every growth stock. At some point in time, the PE drops, even though the E stays the same or even grows (albeit at a lower growth rate). It happened with every growth stock that existed, from Walmart to Dell to Microsoft. Nobody escapes the PE collapse, nobody. It’s simple math – nothing can grow at 25% per year forever. Simply not possible.

    Apple is clearly a successful company, but has run into the dreaded PE collapse, because they’ve reached the point where their growth has started leveling off. Nothing wrong with the company, it just hit the growth wall (which every successful company does at some point).

    So the big questions are just exactly how much will profits grow, and what will be investors’ expectation of said growth? With a PE ratio around 7-9, it seems the downside is limited around $400.

    But Wall Street is emotional and is famous for pushing a stock too high or too low, depending on which direction the herd thunders. Apple probably got bid up too high around $700, and now the question is how low will it get pushed?

    That’s your concern. And in particular you are betting on a specific date in June.

    One would think that even if the herd pushes Apple even lower, that it would have corrected itself by then and be back to around $400 or so. But then again, one can be wrong guessing market reactions in the short term. :)

    Thinking outside the box for a second, if you want to beat a CD for return, have you considered preference shares? They typically yield around 8% or so, with minimal price fluctuation. Far less risk, no fancy instruments needed, higher yield, and you can sell anytime you want. Just a thought…

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