The security of an individual investor’s money is usually their primary concern, and we can often see this reflected in their investment choices. For example, a high level of capital security is guaranteed by Treasury bonds and bank deposits, while there is always a risk of loss along when investing in equities and mutual funds which can affect invested capital to a great extent. Finally, higher levels of risk are always carried by derivative products such as options and futures, as you can lose a bigger amount than that you actually invested.
The concept of capital-protected investments
Lots of mutual fund firms work with the concept of “capital protection”, and some have launched capital guarantee funds, which provide an upward return potential while also guaranteeing the preservation of the invested amount. And this gets even more interesting when individual investors can merge bonds with binary options in order to similarly create their own capital-protected investment products.
U.S. Treasury bonds provide guaranteed risk-free returns. Let’s assume a one-year Treasury bond offers a 5.5% annual rate of return.
Bond returns are calculated using the formula:
Maturity Amount = Principal x (1 + Rate)^Years
For example, investing $5,000 in this bond for one year will get you a maturity amount of:
Maturity Amount = $5,000 x (1+5.5%)^1 = 5,000 x (1+0.055) = $5275.
To preserve this capital of $5,000, the above formula can be reverse engineered: “How much do I need to invest today to get $5,000 as a maturity amount after one-year?
Here, Maturity Amount = $5,000, Rate = 5.5%, Time = 1 year, and we need to find the principal.
Principal = $5,000/(1+0.055)^1 = $4739.34
Investing $4739.34 in the above bond will secure your capital, since you will get $5,000 at maturity.
Binary options as a capital-protected investment
The remaining amount, $5000 – $4739.34 = $260.66, can be used to purchase binary options, which offer high return potential. Say you believe that ABC Inc. stock currently trading at $30 has the potential to hit $55 in one year’s time. A binary call option on this stock with one year to expiry and $50 strike price is available at $37. You can purchase seven such binary options totaling $259, which fits within the available money ($260.66).
If your assumption comes true, and ABC stock reaches the strike price of $50 or higher, each of your binary option will give you a $100 payoff($700 for the seven binary options). Your total return from bond and binary option comes to ($5,000 + $700) = $5,700. On your total invested amount of around $5,000, your net percentage return comes to ($5,700 – $5,000)/$5,000*100% = 14%. In this case, your capital remains protected and you also earn returns that are significantly higher than what you could expect from a bond alone.
If you are incorrect, and ABC’s stock isn’t able to cross the strike price of $50, then you lose your option premium of $259. In this case, you lose out on the excess returns, but your capital is still preserved.
In both the cases, the capital remains protected because of the Treasury bond. The potential of an upward return comes from the binary options.
Though mutual fund firms may provide similar ready-made products, they might cost a lot and might not be suitable for an individual’s choice of investment horizon or underlying assets. Creating such capital-protected investment products offers the flexibility to go for the choice of underlying security, investment horizon, or bonds.