Trade of the month: Dual directional products

Tim Mortimer discusses his trade of the month

The vast majority of retail structured products can be described as long or bull strategies linked to one or more underlyings. This is because their payout will increase (or at least not fall) if the underlying goes up in value. This is the same as being long delta, which means a positive exposure to the market at all times. Included in this type of strategy are all principal-protected and accelerated growth products, reverse convertibles, cliquets and many more.

The opposite strategy would be a short or bear product. These are sometimes issued with a view to provide a hedge or a short-to-medium-term view of a correction in equities, real estate or commodities.

Dual directional products include anything that will potentially benefit from both a rise and fall in the underlying. Such investments have an obvious appeal in that they can produce returns in the event of movements by the underlying in any direction. This gives rise to marketing claims that the product can lead to returns in many, if not all, circumstances, although the reality is likely to be rather different.

The original form of dual directional products was the simple straddle. This consists of a zero-coupon bond plus a call and put. Such a simple straddle, with a zero-coupon bond and call and put options (of reasonable participation), can only exist during periods of high interest rates and low volatility.

Although simple straddles initially appear very attractive, it is likely that the growth principal-protected product would be more popular simply by spending all of the available option premium on a call option. Structured products that appeal to too many scenarios are ultimately self-defeating because they do not offer enough value to anyone with a reasonably firm view. Wanting to go long volatility by buying both a call and put option is a legitimate strategy, but it is unlikely to suit the long-term maturity of a structured product.

In practice, therefore, dual directional products tend to combine this theme with other features.

One example is a straddle investment (combining both a call and a put) that is knocked out if the market hits a certain predefined level on the upside or downside - plus or minus 25% for a one-year product, for instance. Here the upside potential that is taken away to finance the downside opportunity is the presence of the barrier. Therefore, the investor is betting on limited or stable growth in either direction.

A further example is considered in this issue. The product has 125% participation on both upside and downside. While participation on the upside is unlimited, the downside has a final-day barrier so that if the index finishes below 50% the final return is in line with the index.

Here the gains that can be made if the index has risen significantly or fallen by no more than 50% have to be considered alongside the losses that will be felt if the index does fall by more than 50%. While it may be true that this event can be considered unlikely, it dramatically alters the risk profile of the product. The benefits of the dual directional nature of the product come at the price of downside risk.

In conclusion, dual directional products can follow a number of constructions to offer returns in markets that are rising or falling. However, in order for them to be able to produce competitive returns in both situations the standard device is to offer returns for the first phase of the growth or decline in the underlying, and not necessarily hope for unlimited growth in either direction, which simply gets too expensive to provide.