Practical Guide to Buffer vs. Barrier protection
By their very nature the Options and Derivative instruments within Structured Notes can be complicated. Navigating through the multitude of choices that are available can be overwhelming for the Advisor looking to find the best solution for their clients. This is where experience helps a great deal. Having Derivatives experts who have traded these products and can harness their power as well as clearly articulate their risks is of the utmost importance.
In this section we’ll discuss the very high level differences between Buffer and Barrier Options (Equity Knock In - EKI) as they are most often used within Structured notes. More importantly, we’ll discuss how one should think about them.
Buffer options are similar to options available in the listed market. They have a set strike price and start to gain or lose money only once the underlier passes through that strike price. Barrier options (EKI) also have a strike price but the difference lies in their payoff. Once the underlier passes through the strike price the Barrier Option doesn’t just begin to lose money from that point on - it instantly loses the amount from the starting underlier price to the strike price.
Let's think about it in terms of a game where we have $100 and 10 doors in front of us.
In game number one - behind 5 of the doors is someone who will give us $50, in the other 5 doors is someone who will take $20 from us. The expected value of play this game would be 50% * $50 + 50% * -$20 = $15. So if you were to play this game an infinite amount of times you would expect to win, on average, $15 every time.
In game number two - behind 8 of the doors is someone who will give us $50, but this time in the other 2 doors is someone who will take $125 from us. The expected value of play this game would be 80% * $50 + 20% * -$125 = $15. So if you were to play this game an infinite amount of times you would expect to win, on average, $15 every time.
So the expected value of both games is a positive $15, but don’t let that fool you. The distribution of outcomes is very different from one game to the next - as evidenced by the Standard Deviation difference of one from the other. Game two may result in more frequent positive outcomes but the negative outcomes hurt more. Managing the cash flow in each of these scenarios is very dependent on the situation at the time.
The following graph shows a random sampling of payoffs after playing this game 200x. Over time both lines will converge to the expected value of $15 per game but they take very different paths to get there. As you can see from the illustration Game 1 tends to hover around the expected value in a tighter band than Game 2.
For a real world example of this - take a look at the following graph that shows the Peak-to-Trough losses from playing the two games. Game number 2 has much higher variance and carries a risk of far greater drawdowns.
In this simple example, game number 2 is more akin to a Barrier and game number 1 is more like a Buffer. Neither is “right” nor “wrong” - but they have their time and place within a portfolio.
In times of low volatility both Buffer and Barrier options decrease in price. However, Barrier options decrease in price less on a proportional basis than Buffer options and thus can be a useful tool for adding returns to a note or a structure in order to add yield and make it interesting for investors. However, it should be thought about in the context of an entire portfolio and not on a stand alone basis. Managing the risk of these positions during times of stress can be difficult. In high volatility environments, Buffer options can add yield to the portfolio while maintaining their easy to manage risk/return profiles.
While there is no “one size fits all” answer for these questions there are probabilities attached to these investments that should be thought about rigorously and exactly how they fit into the pieces of an overall portfolio.
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