An option contained inside another instrument rather than traded on its own, as in callable bonds, convertibles and structured notes; you hold it whether or not you meant to.
Autocallables, buffered notes and principal-protected certificates are options portfolios in a wrapper. A buffered note is typically a zero-coupon bond plus a call spread plus a short put; a reverse convertible is a bond plus a sold put; a callable bond is a bond plus a bermudan-option you have sold to the issuer. The structures are not exotic — the packaging is.
The cost of the packaging is what buyers rarely see. The embedded options are priced at the issuer's marks, the product is illiquid before maturity, and the investor takes the issuer's credit risk. Replicating the same payoff with listed options is usually possible and usually cheaper, at the price of having to manage it.
Example: a note promising the upside of an index to a 20% cap with a 10% downside buffer over two years. Decomposed, that is a long call spread funded by a short put struck 10% below spot — a position any options account could build, with a visible price for each piece.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Buying a call: payoff at expiry. A 105-strike call bought for 3 loses that whole 3 if the price finishes at or below 105, breaks even at 108, then gains a dollar for every dollar higher. The loss is capped at the premium; the upside is not capped.The bid-ask spread. Buy orders sit below, sell orders above, and the gap between the best bid (50.01) and best ask (50.04) is the spread you pay to cross. Bar length shows the size resting at each price.
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