Fear of tail risk drives new derivative product

A new derivative product will allow buyers and sellers to take levered positions on equity and exchange-traded funds without worrying about tail risk, its designer says.

Clipper, designed by derivatives structuring and trading company Actuarials in Chicago, allows both sides of the transaction to limit their maximum possible gains or losses. A $2 Clipper would restrict the maximum payoff to $2 per underlying share - even if the underlying moved more than $2 away from the original price, the owner of the Clipper would receive only $2 per share from his counterparty. Each counterparty to the trade would give up the maximum possible payout from his trading account at the outset, thus protecting the trade from counterparty risk, Actuarials said.

Actuarials chief executive Adam Burczyk said the product was aimed at a specific class of trader: "We call them the fast-frequency traders - they tend to have portfolio turnover four or more times a year. The efficacy of the Clipper goes away as you go to longer time horizons," he adds, because over long periods the expected movement of a stock, and thus the price target of an investor, may be greater as a percentage of the stock price, thus reducing the advantage of using a Clipper rather than a simple leveraged trade.

He cites the example of Google - a realistic target price increase over a week could be $10 up on a share price of $400. The investor would have to give up only $10 a share as part of a Clipper trade, meaning he had, essentially, 40-to-one leverage. But over a quarter, a target price increase of $150 would be more realistic - the advantage of using a Clipper would drop away as the efficiency fell to close to three-to-one.

But at short time horizons the need for counterparties to fund tail risk will make options more expensive than Clipper trades, he adds.

The Clipper is also a standalone product - it cannot be combined with other derivatives as part of a more elaborate strategy. "It has to be cash settled - there is a mismatch between the value of the underlying security and the payout," explains Burczyk.

At present, Clippers are available on 32 ETFs and stocks traded on Actuarial's Everest trading platform.