Are all Structured Notes Bad?

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orangeinvestor
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Are all Structured Notes Bad?

Post by orangeinvestor »

I've been reading alot about these lately and not alot is positive. Some quickly dismiss them and say they are too complex and the fees are high but I want to dig deeper. I've seen some bad notes that aren't worth it, but during the downturn I bought a few of these products that I thought were really attractive and I'm curious what I am missing. The common comments are:
  • There is credit risk from the underlying issuer. Yes, I agree, the issuer (Barclays, Morgan Stanley, etc) could go bankrupt and that would be a risk
  • There are high fees or commissions associated with them. If you read the prospectus, the brokerage will make 2-5% of the note value for selling the product. However, that commission does not change the terms of the note - it is baked into the offering. So usually that brings the next point:
  • You can probably buy the options and bonds and make one of these yourself. I've tried to match or beat the terms on structured notes and have not been successful. I think this is because they have pricing power as well as access to custom derivatives that I don't.
  • And finally, the performance of the notes usually doesn't include dividends which means your return on the structured note is lower. This is a valid point in that for some downside protection, you are giving up some potential gains. But some notes offer enhanced returns such as this one:
https://sec.report/Document/0001564590-20-011417/ which was offered during the downturn

Here's the basic features:
  • 5 year note tied to the lesser performing of the Dow and the S&P 500
  • If at the end of 5 years, the lesser performing is up, you will receive your initial investment plus 2X return
  • If at the end of 5 years, the lesser performing is down less than 40%, you will receive your initial investment back
  • If at the end of 5 years, the lesser performing is down more than 40%, you will lose the same percentage
So, in exchange for a 5 year commitment and no dividends, you would get 200% upside and a 40% downside barrier.

What am I missing that would make this a bad idea? Does anyone know how I can recreate the structure of this note on my own?
ScubaHogg
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Re: Are all Structured Notes Bad?

Post by ScubaHogg »

How does a 40% otm put option compare in terms of pricing? Could probably only get something a couple of years out, but I would think it’s worth checking. That way you could get the same downside and all of the upside.
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dan23
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Re: Are all Structured Notes Bad?

Post by dan23 »

I don't have an answer to your question, but I do have an added negative to keep in mind if the account is taxable:
    My (non-expert) understanding is if there is principal protection, tax rate becomes ordinary income tax rate instead of LTCG rate.
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    Re: Are all Structured Notes Bad?

    Post by 123 »

    orangeinvestor wrote: Fri Jun 19, 2020 3:43 pm ...
    • If at the end of 5 years, the lesser performing is down more than 40%, you will lose the same percentage
    So, in exchange for a 5 year commitment and no dividends, you would get 200% upside and a 40% downside barrier....
    The way I interpet that is that you DO NOT have downside protection if the bottom falls out. I tollowed the link and came to the same conclusion.
    The closest helping hand is at the end of your own arm.
    skepticalobserver
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    Re: Are all Structured Notes Bad?

    Post by skepticalobserver »

    Sounds like a buffered return enhanced note. Forbes’s view: https://www.forbes.com/sites/billconerl ... 7d8aa32537

    This from the Goldman prospectus (PS-13):

    “Neither you nor any other holder or owner of your notes will have any rights with respect to the underlier stocks, including any voting rights, any right to receive dividends or other distributions…”

    Might this imply that the underlying Index is valued without including dividends? I understand the dividends portion of an Index comprises a substantial part of its value.
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    orangeinvestor
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    Re: Are all Structured Notes Bad?

    Post by orangeinvestor »

    dan23 wrote: Fri Jun 19, 2020 4:17 pm I don't have an answer to your question, but I do have an added negative to keep in mind if the account is taxable:
      My (non-expert) understanding is if there is principal protection, tax rate becomes ordinary income tax rate instead of LTCG rate.
      That is definitely a concern depending on the note, however for the example referenced, the prospectus says the following

      "Your tax basis in the notes will generally be equal to the amount that you paid for the notes. If you hold your notes for more than one year, the gain or loss generally will be long-term capital gain or loss. If you hold your notes for one year or less, the gain or loss generally will be short-term capital gain or loss. Short-term capital gains are generally subject to tax at the marginal tax rates applicable to ordinary income."
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      orangeinvestor
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      Re: Are all Structured Notes Bad?

      Post by orangeinvestor »

      skepticalobserver wrote: Fri Jun 19, 2020 5:29 pm Sounds like a buffered return enhanced note. Forbes’s view: https://www.forbes.com/sites/billconerl ... 7d8aa32537

      This from the Goldman prospectus (PS-13):

      “Neither you nor any other holder or owner of your notes will have any rights with respect to the underlier stocks, including any voting rights, any right to receive dividends or other distributions…”

      Might this imply that the underlying Index is valued without including dividends? I understand the dividends portion of an Index comprises a substantial part of its value.
      The notes are similar but not the same. The downside protection is different. The one I linked has a barrier feature (not a buffer). But the note described in the forbes article would be an example of what I consider a bad structured note. It has a capped upside of 17.4% and a very small (10%) buffer. The note I referenced is uncapped with a 40% downside barrier. Hence my feeling that there are some structured notes that are good.
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      nisiprius
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      Re: Are all Structured Notes Bad?

      Post by nisiprius »

      Read Larry Swedroe's article, Structured Notes: the Exploitation of Retail Investors.
      Thus, the question isn’t whether an investor is being taken advantage of, but only how badly. I’ll review the evidence from the academic research on these products....
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      orangeinvestor
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      Re: Are all Structured Notes Bad?

      Post by orangeinvestor »

      Yup, plenty of articles about how they are all bad and only fools would buy them. But my premise is that not all of them are bad and by example I provided, I think there are some good o es with good benefits.
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      nisiprius
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      Re: Are all Structured Notes Bad?

      Post by nisiprius »

      orangeinvestor wrote: Fri Jun 19, 2020 7:19 pm Yup, plenty of articles about how they are all bad and only fools would buy them. But my premise is that not all of them are bad and by example I provided, I think there are some good o es with good benefits.
      I missed the place where you explained why you think this particular one is a good one with a good benefit.

      In your list you missed the most important drawback, which is that these products are so complicated and obfuscated that they are hard to analyze, raising the likelihood of asymmetrical information--that is, the issuer understands them much better than you do.

      You say "you would get 200% upside and a 40% downside barrier," but that does not tell you whether that is a good investment unless you know quite accurately the probabilities of those outcomes. If I invest 40% of my money in lottery tickets and leave the other 60% in my wallet, I have a 1,000,000% upside and a 40% downside, yet it is not a good investment.

      "...tied to the lesser performing of the Dow and the S&P 500..." This a good example of complication that almost guarantees they will have better information than you have. As you write this, today, have you personally downloaded the Dow and the S&P 500 into a spreadsheet and investigated the statistical distribution of the "lesser performing of the two?" It's just a weird thing, and the only possible reason they could have for linking their note to it is that they have figured out some reason why that is more favorable for them than linking it to one or to the other.

      Not all mousetraps are bad, some of them are jammed and won't snap when the bait is taken. But once I'm convinced me that mousetraps are designed to trap me, I'll just avoid them all, rather than hope that I'm so smart that I can find one that somehow doesn't function as designed.
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      orangeinvestor
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      Re: Are all Structured Notes Bad?

      Post by orangeinvestor »

      Yea I know the argument it's too complicated so it must be evil but I'm looking for anyone who can go deeper and explain.

      The payoff profile is in the note and pretty clear, although not as clear as straight VOO. Im not sure about why 2 indicies but I do know they are highly correlated. And it provides 2x upside leverage and 40% downside barrier. Doesn't seem like a mousetrap.
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      Nate79
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      Re: Are all Structured Notes Bad?

      Post by Nate79 »

      Did you read the wiki on these products?
      How many of the tons of past threads on these sorts of products have you read?
      Here is one with some articles linked you should read:
      viewtopic.php?t=221908

      There are many many other threads. Please report back a summary of those past threads and what is new this time.
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      Re: Are all Structured Notes Bad?

      Post by bberris »

      orangeinvestor wrote: Fri Jun 19, 2020 7:56 pm Yea I know the argument it's too complicated so it must be evil but I'm looking for anyone who can go deeper and explain.

      The payoff profile is in the note and pretty clear, although not as clear as straight VOO. Im not sure about why 2 indicies but I do know they are highly correlated. And it provides 2x upside leverage and 40% downside barrier. Doesn't seem like a mousetrap.
      You are looking at the range of outcomes, not the probability and payoff of the outcomes. It's like drawing to an inside straight, and saying, either I draw my fill card or I don't. 50-50.

      Here is a detailed analysis of some structured notes from 2006.
      https://www.slcg.com/pdf/workingpapers/ ... oducts.pdf
      I doubt your specific deal is covered, but the issuers know what they are doing. On page 10, they looked at some principal protected noted issued by Merrill in 2002 and matured in 2009. A Monte Carlo simulation showed that a simple 75-25 portfolio outperformed the notes 99.5 % of the time.

      So are they all bad? Maybe not all horrible. But they have extra risk, and they are certainly worse than straight forward stock and bond index investing. I just don't see the attraction.
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      orangeinvestor
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      Re: Are all Structured Notes Bad?

      Post by orangeinvestor »

      Nate79 wrote: Fri Jun 19, 2020 8:30 pm Did you read the wiki on these products?
      How many of the tons of past threads on these sorts of products have you read?
      Here is one with some articles linked you should read:
      viewtopic.php?t=221908

      There are many many other threads. Please report back a summary of those past threads and what is new this time.
      In fact I did. That one had only 15% upside leverage and only 15% downsude buffer. Much like the thread, many posted that they are scary and complicated and should be avoided. I have read the wiki and many googled articles.

      Whats new in this thread is this specific note is different. This note has 2x upside and 40% barrier. So again, I'm asking for anyone who can comment beyond "they are complicated". For a similar example of one that I think is terrible look up BAUG. It trades as an etf.
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      Re: Are all Structured Notes Bad?

      Post by talzara »

      orangeinvestor wrote: Fri Jun 19, 2020 3:43 pm https://sec.report/Document/0001564590-20-011417/ which was offered during the downturn

      Here's the basic features:
      • 5 year note tied to the lesser performing of the Dow and the S&P 500
      • If at the end of 5 years, the lesser performing is up, you will receive your initial investment plus 2X return
      • If at the end of 5 years, the lesser performing is down less than 40%, you will receive your initial investment back
      • If at the end of 5 years, the lesser performing is down more than 40%, you will lose the same percentage
      First of all, this is not a 5-year note. The prospectus says that CUSIP 40056YUK8 was issued on March 18, 2020 and will mature on December 17, 2026. That's 6.8 years.

      The S&P 500 and the DJIA are very close to each other, so we can model this as an S&P 500 linked note. The dividend yield of the S&P 500 on March 17, 2020 was 2.4%. Over 6.8 years, that is a compounded return of 17.5%. The structured note can be replicated by:
      1. Buying an S&P 500 ETF and collecting the dividends.
      2. Selling a call at 17.5% in the money.
      3. Buying two calls at the money.
      4. Buying a put at 17.5% out of the money.
      5. Selling a put at 40% out of the money.
      6. Selling a binary put at 40% out of the money for 40% of the underlying price.
      7-year European options are not available on the public markets, but we can look at the price of the December 2022 LEAPS on March 17, 2020. The first five options mostly offset each other. The options bundle have a net cost of only 3.5%, which is 50% of the S&P 500 dividend yield over 2.8 years.

      You take on all the risk, but Goldman keeps half of the dividends. On top of that, Goldman keeps all of the option premium on the binary put. None of it gets passed through to you.

      You can calculate the Black-Scholes prices if you want the exact numbers for 6.8-year European options. It won't change the numbers by much.
      orangeinvestor wrote: Fri Jun 19, 2020 3:43 pm What am I missing that would make this a bad idea? Does anyone know how I can recreate the structure of this note on my own?
      What you're missing is that Goldman Sachs has designed the note to take advantage of your psychological weaknesses.

      While you're being distracted by the 2x upside, you're not noticing that Goldman is picking your pocket. Most people don't have Black-Scholes calculators in their heads, but the financial engineers at Goldman Sachs do.
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      Re: Are all Structured Notes Bad?

      Post by orangeinvestor »

      Wow. Thank you. I knew there would be someone here that could help educate me. And apologies for the error on the 5 year term.
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      Re: Are all Structured Notes Bad?

      Post by talzara »

      orangeinvestor wrote: Fri Jun 19, 2020 7:56 pm The payoff profile is in the note and pretty clear, although not as clear as straight VOO. Im not sure about why 2 indicies but I do know they are highly correlated. And it provides 2x upside leverage and 40% downside barrier. Doesn't seem like a mousetrap.
      That's what makes it a mousetrap. The cheese is the 2x upside leverage. The trap is that you don't get dividends.
      orangeinvestor wrote: Fri Jun 19, 2020 3:43 pm
      • And finally, the performance of the notes usually doesn't include dividends which means your return on the structured note is lower. This is a valid point in that for some downside protection, you are giving up some potential gains. But some notes offer enhanced returns such as this one:
      This paragraph is a perfect example of how structured notes exploit your psychological weaknesses. You already know that you don't get dividends, but you immediately decide that it's not important. Then you start talking about "enhanced returns."

      The "enhanced returns" distract you from understanding why the dividends are important. That's why they put them in there.
      • Goldman keeps 50% of the dividends. You get none of it.
      • Goldman keeps 100% of the binary put option premium. You get none of it.
      • You take all the risk.
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      Re: Are all Structured Notes Bad?

      Post by MarkRoulo »

      orangeinvestor wrote: Fri Jun 19, 2020 3:43 pm What am I missing that would make this a bad idea? Does anyone know how I can recreate the structure of this note on my own?
      Talzara has addressed the details for THIS note, but at a slightly higher level you need to understand that the issuers of these things are NOT assuming any market risk. Instead, they build these things so that with dynamic hedging they have a locked in profit. That profit comes from you and the people taking the other sides of the hedge.

      If you know that the notes have a built-in risk free profit for the issuer, the odds are poor that it is a good deal for you.
      talzara
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      Re: Are all Structured Notes Bad?

      Post by talzara »

      MarkRoulo wrote: Fri Jun 19, 2020 9:57 pm Talzara has addressed the details for THIS note, but at a slightly higher level you need to understand that the issuers of these things are NOT assuming any market risk. Instead, they build these things so that with dynamic hedging they have a locked in profit. That profit comes from you and the people taking the other sides of the hedge.

      If you know that the notes have a built-in risk free profit for the issuer, the odds are poor that it is a good deal for you.
      All financial instruments have profits included in the price. If you buy options, the market maker is also dynamically hedging and making a risk-free profit from the option value.

      Structured notes are a bad deal because of how profitable they are for the issuer. The profit margin is around 50%. There are many different ways to structure the payoff. It could be 50% of the underlying returns, or 50% of the option value, or 50% of the dividends. The bank takes about half of the earnings, but you take all the risk.

      If there were a structured note with a 5% profit margin, then it would be a good deal. You can't buy 7-year options on the public markets, so 5% would be a reasonable fee to pay for access to long-dated options. However, no bank has ever issued a structured note with a 5% profit margin.

      I've never seen a structured note that was a good deal. They don't exist.
      UsualLine
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      Re: Are all Structured Notes Bad?

      Post by UsualLine »

      Is there a secondary market for these? At some price they will be a value.
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      Re: Are all Structured Notes Bad?

      Post by WoodSpinner »

      All,

      What a great thread and learning opportunity! It’s this kind of insight that makes this forum so valuable to me.

      Bookmarked for future reference, just in-case.

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      Re: Are all Structured Notes Bad?

      Post by Nate79 »

      And this was the same conclusion in all the old threads, in the wiki, etc. And the same calculations have been shown multiple times.
      talzara
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      Re: Are all Structured Notes Bad?

      Post by talzara »

      nisiprius wrote: Fri Jun 19, 2020 7:34 pm "...tied to the lesser performing of the Dow and the S&P 500..." This a good example of complication that almost guarantees they will have better information than you have. As you write this, today, have you personally downloaded the Dow and the S&P 500 into a spreadsheet and investigated the statistical distribution of the "lesser performing of the two?" It's just a weird thing, and the only possible reason they could have for linking their note to it is that they have figured out some reason why that is more favorable for them than linking it to one or to the other.
      No, in this case they put it in just to distract you. The Dow Jones and the S&P 500 are highly correlated to each other, so it's almost the same as a structured note linked only to the S&P 500. It increases Goldman's returns by a couple of percent, but it's not where most of the profit comes from.

      Structured notes are designed to take advantage of psychological weaknesses. The more complicated the note, the more likely it is that the investor will focus on one feature of the note. The OP focused on the 2x leverage, and you focused on the worst-of-two. Both of you missed the fact that the options only cost half of the dividend yield of the underlying index, which is where Goldman is making most of its money.

      Every time I see a structured note on Bogleheads, there's always a catch. The banks can be very creative when they design the catch:
      • Here is a trigger GEARS note that is linked to a foreign stock index. However, it applies the percentage gain on the index in US dollars without converting from the foreign currency: viewtopic.php?t=285805#p4645770
      • Here is an auto-callable contingent interest note where one of the indexes has a higher beta, and you also lose the premium. A 24.5% loss on the better index turns into a 36% loss on the structured note: viewtopic.php?f=1&t=197202#p3012639
      • Here is a trigger yield optimization note that is disguised as a coupon-paying bond. However, it's actually a bundle of two options, and the bank keeps 39% of the option premium: viewtopic.php?t=109689#p1596779
      The Goldman Sachs trigger buffer note in this thread requires six derivatives contracts just to construct the S&P 500 portion of the note. Then it turns them into worst-of-two options on the Dow Jones as well. This note is designed to be difficult to understand.

      Goldman Sachs is much greedier than UBS, which only kept 39% of the option premium for the trigger yield optimization note. Goldman isn't satisfied with just 50% of the dividends. It also has to take 100% of the binary put option premium, and then it uses worst-of-two to squeeze out another couple of percent.
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      Re: Are all Structured Notes Bad?

      Post by VaR »

      To add to GS's profits, isn't the dividend yield of the Dow 30 higher than the dividend yield of the S&P 500? In addition, even though they are highly correlated, GS also gets to pocket the 5 year variance between the two indices, regardless of which is higher after 5 years. This means they are also pocketing the premium on the Dow 30 vs S&P 500 spread option that the note-buyers are given them. I don't know the value of this spread option and I don't have access to professional market data anymore, but I see from a web search that the 3 month correlation coefficient between the two indices is 0.86.
      glorat
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      Re: Are all Structured Notes Bad?

      Post by glorat »

      MarkRoulo wrote: Fri Jun 19, 2020 9:57 pm
      orangeinvestor wrote: Fri Jun 19, 2020 3:43 pm What am I missing that would make this a bad idea? Does anyone know how I can recreate the structure of this note on my own?
      Talzara has addressed the details for THIS note, but at a slightly higher level you need to understand that the issuers of these things are NOT assuming any market risk. Instead, they build these things so that with dynamic hedging they have a locked in profit. That profit comes from you and the people taking the other sides of the hedge.

      If you know that the notes have a built-in risk free profit for the issuer, the odds are poor that it is a good deal for you.
      THIS is the reason why I consider all structured notes "bad". Every note sold is practically risk free money for the issuer.
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      Re: Are all Structured Notes Bad?

      Post by itsmeagain »

      Here’s another way of thinking about why this note is less attractive than meets the eye. It’s similar to talzara’s explanation, but perhaps easier to understand for those who aren’t familiar with options.

      The figure in the prospectus on PS-9
      https://sec.report/Document/0001564590-20-011417/
      shows payouts relative to the underlying index change.

      It looks incredible at first glance. Same payout as index from 0 to 60%. And better payout everywhere else (except right at 100%, where it's the same as the index). How can you lose?

      It’s all about the dividends you don’t get. Almost 7 years worth. And on the Dow (one of the two benchmarks, and the one that pays the higher rate that you won’t get), the yield is currently around 2.3%, and it was around 3% when this note was constructed near the market botton. If you compound that 3% for 6.75 years, then it’s worth over 20%.

      So the comparison to the stock market would not be the 1:1 dashed line, but a line that’s moved up across the board by 20% or so. (I tried to post an image here, but I was not able to do so.)

      So now you see that you'd beat the stock market index only in two oddly disconnected regions: if the index (without dividends) gains more than about 20%, or if the index loses between about 25% and 40%.

      The dashed line in the prospectus, by contrast, is more like a comparison to a 0% bank account.
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      orangeinvestor
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      Re: Are all Structured Notes Bad?

      Post by orangeinvestor »

      Thank you itsmeagain, This is really helpful as well. I started to create an excel spreadsheet taking into account annual dividends and comparing the note to a hypothetical VOO purchase. As you state below, the payoff profile is attractive for some regions and worse in the others. Despite that, for the loss of liquidity and credit risk it certainly wasn't as awesome as I thought it was.
      Last edited by orangeinvestor on Sun Jun 21, 2020 2:17 pm, edited 1 time in total.
      talzara
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      Re: Are all Structured Notes Bad?

      Post by talzara »

      VaR wrote: Sat Jun 20, 2020 8:33 pm To add to GS's profits, isn't the dividend yield of the Dow 30 higher than the dividend yield of the S&P 500? In addition, even though they are highly correlated, GS also gets to pocket the 5 year variance between the two indices, regardless of which is higher after 5 years. This means they are also pocketing the premium on the Dow 30 vs S&P 500 spread option that the note-buyers are given them. I don't know the value of this spread option and I don't have access to professional market data anymore, but I see from a web search that the 3 month correlation coefficient between the two indices is 0.86.
      That's right, but most of Goldman's profit comes from the dividend yield.

      I only looked at one index to keep it simple. The Goldman Sachs trigger buffer note is already a bad deal for the investor with only the S&P 500. Worst-of-two only makes it worse for the investor.
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      Re: Are all Structured Notes Bad?

      Post by talzara »

      UsualLine wrote: Sat Jun 20, 2020 10:16 am Is there a secondary market for these? At some price they will be a value.
      I don't see how there could be enough liquidity to trade. LEAPS that are far out of the money can go weeks between trades, and those are on heavily-traded ETFs with expiration dates within the next three years. These structured notes are even longer-dated, and they have more complex payoff profiles on multiple indexes. There might only be one trade a year.
      UsualLine
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      Re: Are all Structured Notes Bad?

      Post by UsualLine »

      So another strike against these that hasn’t been mentioned yet is lack of liquidity. Something that you have to hold for 6 years should include a liquidity premium.

      Thanks for the great explanations everyone.
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      Re: Are all Structured Notes Bad?

      Post by ikowik »

      Fascinating thread. Nigerian scam artists have nothing on structured notes. Bordering on unethical, criminal; the buyer plays a big role by being "sophisticated" enough to think he/ she understands these things better than the seller.

      See: https://www.bloomberg.com/opinion/artic ... ured-notes
      barnaby444
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      Re: Are all Structured Notes Bad?

      Post by barnaby444 »

      Reviving this thread after finding it through search, I hope that's not bad form.
      itsmeagain wrote: Sun Jun 21, 2020 12:30 pm So now you see that you'd beat the stock market index only in two oddly disconnected regions: if the index (without dividends) gains more than about 20%, or if the index loses between about 25% and 40%.
      talzara wrote: Sun Jun 21, 2020 2:14 pm most of Goldman's profit comes from the dividend yield.
      I've read all the replies and some other threads on the same topic. I understand how mechanically the combination of options that @talzara posted replicates the note, and that Goldman is making a basically risk free profit from issuing the note. Yet, I still can't intuitively wrap my head around how this ends up being a bad deal for the note investor. As @itsmeagain said, you only beat the market on the upside if the index (sans dividends) gains more than about 20% in ~7 years. But that's only 2.7% annually. In the last 7 years, the S&P has returned about 116% without dividends, or almost 12% per year. This note would've doubled that to a 232% total return, easily beating the S&P return with dividends of 147.5%.

      I understand past performance is no guarantee etc., but over the last 25 years the S&P has averaged 7% annually without dividends, so 2.7% annually seems like a pretty low bar. Plus, you get the note's downside protection. Meanwhile, it's difficult for me to replicate the note myself with options as an unsophisticated retail investor, so paying Goldman something for it seems reasonable.

      Is it really the case that this is purely "psychological weakness?" I understand that Goldman, a sophisticated institution, is not going to come out a loser. But I am wondering if maybe that's okay from the investor's perspective, because GS can only make a lot of money by selling this note to many many clients, which is their business model, which is entirely different than my "business model" as a retail investor trying to save for retirement. I think of it as akin to a mutual fund manager earning their expense ratio. Sure, they come out ahead no matter what and the investor takes all the risk, but that doesn't mean the managers are fleecing the investors. It is not practical for me to take the "other side" of that trade and become a fund manager.

      Ultimately, even after reading all the warnings and caveats in this thread, it seems like the note provides large upside with reasonably likely probability, and small downside (relative to owning the S&P). Even if we assume that the downside is more likely, I'm not seeing how this is necessarily a bad deal for a risk averse investor.

      Thoughts?
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      Re: Are all Structured Notes Bad?

      Post by hi_there »

      Hi. Just a couple of things to comment on, without going to deep down the rabbit hole.
      talzara wrote: Sun Jun 21, 2020 2:14 pm most of Goldman's profit comes from the dividend yield.
      This is a misrepresentation, since a high dividend yield is a pricing component that lowers the underlying index's forward price and generally improves the terms of the note. The issuing bank's mark-to-market gain might still partly come from an adjustment to the forward curve, but the bank will certainly not mark dividends to zero for pricing the note.
      barnaby444 wrote: Wed May 19, 2021 9:23 am Yet, I still can't intuitively wrap my head around how this ends up being a bad deal for the note investor.
      Nowadays, on a vanilla structure like this, the bank's mark-to-market gain will be relatively small: usually 0.15% to 0.50%. However, there will probably be a commission added to that by the FA. What constitutes a "good" or "bad" deal is whether the investor is willing to pay such costs to achieve their intended payout profile, and whether they have the ability to do it at a lower cost through some other method.
      barnaby444 wrote: Wed May 19, 2021 9:23 am I understand that Goldman, a sophisticated institution, is not going to come out a loser.
      Hmm... there are actually some more complicated structured notes that have caused huge losses for investment banks, since the risk is not easy to manage. You can look up "autocallable notes" as an example. So, it is not always a good assumption that banks have the upper hand, especially in an increasingly competitive market.
      barnaby444 wrote: Wed May 19, 2021 9:23 am But I am wondering if maybe that's okay from the investor's perspective, because GS can only make a lot of money by selling this note to many many clients, which is their business model, which is entirely different than my "business model" as a retail investor trying to save for retirement.
      Yes, this is an astute comment. With that being said, structured notes have higher cost than most other financial products - which is the price for their complicated engineering. The investor must decide if these costs are justified by the product.
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      firebirdparts
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      Re: Are all Structured Notes Bad?

      Post by firebirdparts »

      barnaby444 wrote: Wed May 19, 2021 9:23 am I've read all the replies and some other threads on the same topic. I understand how mechanically the combination of options that @talzara posted replicates the note, and that Goldman is making a basically risk free profit from issuing the note. Yet, I still can't intuitively wrap my head around how this ends up being a bad deal for the note investor.
      This is a great thread. I learned what binary options are from this thread.

      I think your question is valid. The fact is, it's your money. If you could replicate these options, then you could have risk free profit, but you'd be limited to the risk free profit. The customer does retain something of the risk premium. If the price of the S&P500 goes up 35% you'd make 70%. The customer does have a buffer. If it goes down 39% you'd make zero %. In the first case I suppose you'd make more money than Goldman Sachs did, although I have no idea what that binary option is worth. You would be taking this dough from the counterparty (not Goldman Sachs).

      Since it's not their money, and it's risk free (within reason), they can do it a jillion times. You can only do it once.

      I find these option structures interesting. They are pretty innovative, really. It may help to start with some simpler ones and think about how they do that.
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      Re: Are all Structured Notes Bad?

      Post by barnaby444 »

      firebirdparts wrote: Wed May 19, 2021 10:36 am This is a great thread. I learned what binary options are from this thread.
      Same!

      Thanks for the perspectives @firebirdparts and @hi_there.
      HootingSloth
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      Re: Are all Structured Notes Bad?

      Post by HootingSloth »

      I will share an anecdote for what it is worth. One of my very good friends from college worked for a while as someone who designs these kinds of instruments for a leading financial institution. I had a long conversation with him one night about what went into that process, which was interesting. At the end, I asked him how he invested his own money. He told me he put it all in passive index funds.

      A few years later, he left that job. He told me that he was tired of designing products that did not seem to be in the best interest of the people who purchased them.
      Global Market Portfolio + modest tilt towards volatility (80/20->60/40 as approach FI) + modest tilt away from exchange rate risk (80% global+20% U.S. stocks; currency-hedge bonds) + tax optimization
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      Re: Are all Structured Notes Bad?

      Post by nyclon »

      orangeinvestor wrote: Fri Jun 19, 2020 7:56 pm Yea I know the argument it's too complicated so it must be evil but I'm looking for anyone who can go deeper and explain.

      The payoff profile is in the note and pretty clear, although not as clear as straight VOO. Im not sure about why 2 indicies but I do know they are highly correlated. And it provides 2x upside leverage and 40% downside barrier. Doesn't seem like a mousetrap.
      I structured these at a bank. In plain english, I used an excel model to put the lego pieces together to create them. My opinion on the "asymmetric"-ness of the information is simply the following:
      -The bank's treasury lends money to the trading desk to put these together. You don't know where they're pricing the money. But, because banks are in competition with these deals, it's probably not that bad of a markup since they're competing on rates. Only the big banks do most of these deals and that means "cheap" debt.
      -Most of the money is made on the options themselves. The biggest inputs are delta and vega. Every underlying has a bid/ask for delta and vega. It's the same spread/market that you'll find on etrade/vanguard for a plain vanilla option as for these. But you may pay ask vs. mid. Or, slightly over if it's funky structure (basket of stocks, etc will include gamma). Nothing different than if you wanted to buy a pre-built set of furniture instead of Ikea. That's the key markup.

      In terms of probability of outcomes - yes the docs model them appropriately. If you are ok trading plain vanilla options you should be ok with the outcome math in these docs. If you don't want to trade options because you don't believe in monte carlo simulation don't buy these structures.
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      Stinky
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      Re: Are all Structured Notes Bad?

      Post by Stinky »

      HootingSloth wrote: Wed May 19, 2021 12:23 pm I will share an anecdote for what it is worth. One of my very good friends from college worked for a while as someone who designs these kinds of instruments for a leading financial institution. I had a long conversation with him one night about what went into that process, which was interesting. At the end, I asked him how he invested his own money. He told me he put it all in passive index funds.

      A few years later, he left that job. He told me that he was tired of designing products that did not seem to be in the best interest of the people who purchased them.
      Thanks for sharing.

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      talzara
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      Re: Are all Structured Notes Bad?

      Post by talzara »

      barnaby444 wrote: Wed May 19, 2021 9:23 amI've read all the replies and some other threads on the same topic. I understand how mechanically the combination of options that @talzara posted replicates the note, and that Goldman is making a basically risk free profit from issuing the note. Yet, I still can't intuitively wrap my head around how this ends up being a bad deal for the note investor. As @itsmeagain said, you only beat the market on the upside if the index (sans dividends) gains more than about 20% in ~7 years. But that's only 2.7% annually. In the last 7 years, the S&P has returned about 116% without dividends, or almost 12% per year. This note would've doubled that to a 232% total return, easily beating the S&P return with dividends of 147.5%.
      It's a bad deal because Goldman Sachs is charging more than 200% of the option value. If it charged 105% of the option value, then 5% would be a reasonable fee to pay for access to 7-year options.

      Since you can't buy 7-year options as an individual investor, you cannot replicate the note exactly. However, you can approximate it by rolling LEAPS. This is an expensive strategy since you're using American options on a shorter duration, but 200% gives you a lot to work with. Options cost a lot less when they're out-of-the-money.

      When you do it yourself, you have a 50/50 chance of picking the better index. Goldman Sachs always gives you the worst of two indexes.
      barnaby444 wrote: Wed May 19, 2021 9:23 am I think of it as akin to a mutual fund manager earning their expense ratio.
      On Bogleheads, we consider an expense ratio of 1.4% to be very high.
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      Re: Are all Structured Notes Bad?

      Post by talzara »

      hi_there wrote: Wed May 19, 2021 9:53 am
      talzara wrote: Sun Jun 21, 2020 2:14 pm most of Goldman's profit comes from the dividend yield.
      This is a misrepresentation, since a high dividend yield is a pricing component that lowers the underlying index's forward price and generally improves the terms of the note.
      It improves the terms of the note for Goldman Sachs. It makes the note worse for the investor.

      The note is linked to the price return of the index, not the total return. A high dividend yield reduces the forward price of the index, so the investor will get a lower return.
      hi_there wrote: Wed May 19, 2021 9:53 am The issuing bank's mark-to-market gain might still partly come from an adjustment to the forward curve, but the bank will certainly not mark dividends to zero for pricing the note.
      I did not say that the bank was marking dividends to zero. In fact, I did not say anything about Goldman's accounting policies.

      What I gave was an intuitive way of understanding why Goldman Sachs is making a profit on the note. The first five options almost offset each other, and the net cost is about 50% of the dividend yield. The remaining 50% is Goldman's profit, including the binary put that I didn't price.

      That doesn't mean Goldman is actually marking the dividends to 50% and the binary put to zero. It just means that Goldman's profits add up to that number.

      The structured note is a bundle that cannot be unbundled. You can't turn in a structured note and demand that Goldman give you the component securities. You can only get the returns on the whole bundle.
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      Re: Are all Structured Notes Bad?

      Post by talzara »

      HootingSloth wrote: Wed May 19, 2021 12:23 pm I will share an anecdote for what it is worth. One of my very good friends from college worked for a while as someone who designs these kinds of instruments for a leading financial institution. I had a long conversation with him one night about what went into that process, which was interesting.
      I'd be very interested in hearing what went into that process.
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      Re: Are all Structured Notes Bad?

      Post by hi_there »

      talzara wrote: Wed May 19, 2021 4:42 pm
      hi_there wrote: Wed May 19, 2021 9:53 am
      talzara wrote: Sun Jun 21, 2020 2:14 pm most of Goldman's profit comes from the dividend yield.
      This is a misrepresentation, since a high dividend yield is a pricing component that lowers the underlying index's forward price and generally improves the terms of the note.
      It improves the terms of the note for Goldman Sachs. It makes the note worse for the investor.

      The note is linked to the price return of the index, not the total return. A high dividend yield reduces the forward price of the index, so the investor will get a lower return.
      hi_there wrote: Wed May 19, 2021 9:53 am The issuing bank's mark-to-market gain might still partly come from an adjustment to the forward curve, but the bank will certainly not mark dividends to zero for pricing the note.
      I did not say that the bank was marking dividends to zero. In fact, I did not say anything about Goldman's accounting policies.

      What I gave was an intuitive way of understanding why Goldman Sachs is making a profit on the note. The first five options almost offset each other, and the net cost is about 50% of the dividend yield. The remaining 50% is Goldman's profit, including the binary put that I didn't price.

      That doesn't mean Goldman is actually marking the dividends to 50% and the binary put to zero. It just means that Goldman's profits add up to that number.

      The structured note is a bundle that cannot be unbundled. You can't turn in a structured note and demand that Goldman give you the component securities. You can only get the returns on the whole bundle.
      I think the math is more nuanced than what you are describing here. For example, it is not possible to quantify the effect of dividend yield on this note price without knowing the individual (fwd) Deltas of the two index underliers. I'm also not sure if you are saying that you have priced the worst-of options in this package, or if you know the T0 mark-to-market profit made by GS. I'm not sure if it even matters. It was just unclear how you linked the bank's profit to an arbitrarily chosen pricing parameter.
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      Re: Are all Structured Notes Bad?

      Post by talzara »

      hi_there wrote: Wed May 19, 2021 5:48 pm I think the math is more nuanced than what you are describing here. For example, it is not possible to quantify the effect of dividend yield on this note price without knowing the individual (fwd) Deltas of the two index underliers. I'm also not sure if you are saying that you have priced the worst-of options in this package, or if you know the T0 mark-to-market profit made by GS. I'm not sure if it even matters. It was just unclear how you linked the bank's profit to an arbitrarily chosen pricing parameter.
      It is not necessary to do that calculation unless you want two digits of precision.

      Worst of two makes the note worse for the investor, not better.

      I also did my analysis with American options. European options make the note worse for the investor, not better.

      The second digit of precision may increase someone's bonus at Goldman Sachs, but it doesn't matter for the investor. It's enough to know that the first digit is 2. It's a bad investment at 220% of the option value. It's even worse at 240% of the option value.
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      Re: Are all Structured Notes Bad?

      Post by hi_there »

      talzara wrote: Thu May 20, 2021 10:57 am
      hi_there wrote: Wed May 19, 2021 5:48 pm I think the math is more nuanced than what you are describing here. For example, it is not possible to quantify the effect of dividend yield on this note price without knowing the individual (fwd) Deltas of the two index underliers. I'm also not sure if you are saying that you have priced the worst-of options in this package, or if you know the T0 mark-to-market profit made by GS. I'm not sure if it even matters. It was just unclear how you linked the bank's profit to an arbitrarily chosen pricing parameter.
      It is not necessary to do that calculation unless you want two digits of precision.

      Worst of two makes the note worse for the investor, not better.

      I also did my analysis with American options. European options make the note worse for the investor, not better.

      The second digit of precision may increase someone's bonus at Goldman Sachs, but it doesn't matter for the investor. It's enough to know that the first digit is 2. It's a bad investment at 220% of the option value. It's even worse at 240% of the option value.
      You completely lost me.
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      Re: Are all Structured Notes Bad?

      Post by Oregano »

      Most of the time, you would not want to buy a structured note at issue. However, if you buy one like the OP did when implied volatility is extremely high, it might not be a bad deal - it is giving you a way to sell volatility over a long time horizon.

      Now, it will still be the case that the issuer is building some profit for itself into the note so technically you will always underperform the theoretical market pricing at that time, but here's the catch: an individual investor can't actually replicate this note on his/her own.

      I don't even know if this is accurate, but Talzara wrote the following could be used to replicate this with 6.8 year options, so for argument's sake, let's assume it is correct.
      "Buying an S&P 500 ETF and collecting the dividends.
      Selling a call at 17.5% in the money.
      Buying two calls at the money.
      Buying a put at 17.5% out of the money.
      Selling a put at 40% out of the money.
      Selling a binary put at 40% out of the money for 40% of the underlying price."


      Good luck putting this on as a retail investor!

      If you look at comparable structured notes today, the terms are probably very weak, but the OP got in when volatility was at all-time highs. Obviously it has been a good purchase with hindsight, but if I had been offered some of that in March 2020, I might have bought some myself.

      P.S. It does trade in the secondary market, but very infrequently. An investor sold some to a dealer at 205.535% of the offering price on 4/23/21. (http://finra-markets.morningstar.com/Bo ... =GS4966899). So the OP could sell now and will have outperformed the broad market by about 40% since purchase (but get less than the mark-to-market value, of course), or hold on and see what happens.
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      Re: Are all Structured Notes Bad?

      Post by itsmeagain »

      Oregano wrote: Fri May 21, 2021 10:40 am Most of the time, you would not want to buy a structured note at issue. However, if you buy one like the OP did when implied volatility is extremely high, it might not be a bad deal - it is giving you a way to sell volatility over a long time horizon.

      ...

      If you look at comparable structured notes today, the terms are probably very weak, but the OP got in when volatility was at all-time highs. Obviously it has been a good purchase with hindsight, but if I had been offered some of that in March 2020, I might have bought some myself.
      If anyone has a link, I'd be interested in seeing the terms of a similarly structured note just (or about to be) issued now, to get some sense of the current risk-reward structure.

      It does seem as if these long-dated options can give some interesting opportunities that are otherwise unavailable to individual investors.
      WhenIsADoorNotADoor
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      Re: Are all Structured Notes Bad?

      Post by WhenIsADoorNotADoor »

      I see cart blanche arguments against structured products being made continuously by individuals who have the background, expertise and interest in managing multiple options contracts over long periods of time. Unfortunately, this represents a sliver of retail investors, most of whom don't have the interest in investing in options at all. Plus options are subject to the their own "psychological traps" and require a far higher level of investing competence, which is why the average investor actually loses money when they begin to trade even simple strategies. You have to remember that structured products are bought by people who want a hands off approach to their investments. People who trade options generally don't buy structured investments, so what is happening here is really two separate conversations. Conversation 1: Is the average retail investor ever better off buying structured products at times? and Conversation 2: Is the reasonably educated options trader ever better off buying structured products?

      It really does a disservice to the average investor to have 90% of the articles on structured notes resembling fire and brimstone sermons as opposed to the nuanced conversation that should be taking place around them. Yes, when volatility is low, structured notes are often mediocre. A similar investment now would probably offer zero leverage with a 40% barrier and might even be capped on max upside if you were including these two indices. But as the original poster referenced in their real world example, that is not always the case. Sometimes attractive terms are available, and even more often, individuals do not have the time, interest or expertise to pull off the correct options trading strategy to match their life cycle need. Should a 57 year old looking to retire in 6 years who is on the edge of having the right savings level have avoided this product and tried trading options for the first time?

      It's great to get on message boards and talk about perfect scenarios where time and expertise is free to everyone, but that's just not reality. So to the original poster, I would say this - when the world was falling apart and people were unsure of how long it was going to take for COVID to have a vaccine, would you have actually gone out and put together your own options trading strategy? Or did having a simple solution with a 40% barrier give you the psychological comfort to get off the sidelines in the depths of the market correction and into the market on a product offering 2x leverage? People can call it a psychological trap that you're falling into by letting firms create these products for you, but this is a disingenuous argument. Before cellphones, why did people waste their time paying someone to build a watch when they could just have made it themselves? Oh right, because they didn't want to learn how or spend the time doing it, but they still wanted to know what time it was.
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      Re: Are all Structured Notes Bad?

      Post by David Jay »

      WhenIsADoorNotADoor wrote: Tue Jun 08, 2021 10:30 amConversation 1: Is the average retail investor ever better off buying structured products at times?
      I'll take FINRA/SEC on this question: https://www.sec.gov/news/press/2011/2011-118.htm
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      Re: Are all Structured Notes Bad?

      Post by Nate79 »

      WhenIsADoorNotADoor wrote: Tue Jun 08, 2021 10:30 am I see cart blanche arguments against structured products being made continuously by individuals who have the background, expertise and interest in managing multiple options contracts over long periods of time. Unfortunately, this represents a sliver of retail investors, most of whom don't have the interest in investing in options at all. Plus options are subject to the their own "psychological traps" and require a far higher level of investing competence, which is why the average investor actually loses money when they begin to trade even simple strategies. You have to remember that structured products are bought by people who want a hands off approach to their investments. People who trade options generally don't buy structured investments, so what is happening here is really two separate conversations. Conversation 1: Is the average retail investor ever better off buying structured products at times? and Conversation 2: Is the reasonably educated options trader ever better off buying structured products?

      It really does a disservice to the average investor to have 90% of the articles on structured notes resembling fire and brimstone sermons as opposed to the nuanced conversation that should be taking place around them. Yes, when volatility is low, structured notes are often mediocre. A similar investment now would probably offer zero leverage with a 40% barrier and might even be capped on max upside if you were including these two indices. But as the original poster referenced in their real world example, that is not always the case. Sometimes attractive terms are available, and even more often, individuals do not have the time, interest or expertise to pull off the correct options trading strategy to match their life cycle need. Should a 57 year old looking to retire in 6 years who is on the edge of having the right savings level have avoided this product and tried trading options for the first time?

      It's great to get on message boards and talk about perfect scenarios where time and expertise is free to everyone, but that's just not reality. So to the original poster, I would say this - when the world was falling apart and people were unsure of how long it was going to take for COVID to have a vaccine, would you have actually gone out and put together your own options trading strategy? Or did having a simple solution with a 40% barrier give you the psychological comfort to get off the sidelines in the depths of the market correction and into the market on a product offering 2x leverage? People can call it a psychological trap that you're falling into by letting firms create these products for you, but this is a disingenuous argument. Before cellphones, why did people waste their time paying someone to build a watch when they could just have made it themselves? Oh right, because they didn't want to learn how or spend the time doing it, but they still wanted to know what time it was.
      Welcome to Bogleheads and your first post happens to be on structured notes.
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      galeno
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      Re: Are all Structured Notes Bad?

      Post by galeno »

      I vote yes. All bad. This is a Boglehead board after all.
      KISS & STC.
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