JPMorgan's optimal entry return enhanced notes linked to Apple stock offer innovative buffer

By Emma Trincal

New York, July 19 - JPMorgan Chase & Co.'s 0% capped optimal entry return enhanced notes due Aug. 23, 2013 linked to the common stock of Apple Inc. offer an inventive feature called lookback, which sources said allows investors to buy future protection from early losses in the stock.

The lookback price will be the stock's lowest closing price during the 30 calendar days beginning on the pricing date, according to a 424B2 filing with the Securities and Exchange Commission.

The lookback can serve as a strike for a buffer and for enhanced upside. When this strike is significantly below the initial price, investors benefit on both ends, a structurer explained.

If the final stock price is greater than the lookback price, the payout at maturity will be par plus double the gain from the lookback price, up to a maximum return of at least 20%. The exact cap will be set at pricing.

If Apple stock finishes below the lookback price, investors will lose 1% for every 1% decline below the lookback price.

"It's been done before, and people may be coming back to it," the structurer said.

"It's a pretty interesting feature, but it's not easy to explain to the client, and that can be the problem."

How it works

In a table, the prospectus provides an illustration of the hypothetical total return at maturity, assuming a $1,000 initial stock price and a lookback of $600.

One example shows a final stock price of $615. While the final price is very much below the initial price of $1,000, it is still above the lookback by 2.5%. The actual total return, which incorporates leverage, would then be 2.5% times two. At maturity, investors would earn a 5% return over par, or $1,050.

Sources noted that the $600 lookback price on which the prospectus based its assumptions represents a 40% decline within 30 days from pricing. It may be a good outcome but not necessarily a realistic one given the bullish path of Apple shares.

"It's an interesting note. You really have to sit down and take a look at it," said Steve Doucette, financial adviser at Proctor Financial.

"It is hard to wrap your arms around all the scenarios, but once you understand it, it's pretty straightforward."

Downside protection

The notes may be used as a way to buy protection from an early pullback.

"I do think the market is range bound for the foreseeable future. It's a way to capture excess return instead of owning the stock," Doucette said. "The summer may not be a bad time to enter."

Sources said that the most favorable scenario would be a strong decline in the stock early on. This outcome would give investors a thick buffer with a wide range of protection from the initial price.

But there is an element of risk in that narrow window of time, sources said.

"You're betting that your stock is going to go down in the beginning. If it doesn't go down in the first 30 days, you're long the stock on the downside. It's a leveraged and capped note with no buffer," Doucette said.

"If it does go down, it gives you some protection on the downside, although you don't know how much in advance. You're trying to capture a little bit of outperformance on a volatile stock."

The lookback is like an option, the structurer said.

"Maybe you'll benefit from it, maybe not."

Pre-earnings pricing

Matt Medeiros, president and chief executive of the Institute for Wealth Management, questioned the timing of the deal, which is set to price Friday.

"The note is coming out prior to their earning report next week. If Apple continues to report positive earnings, then frankly the initial price could be the lowest price," he said.

Medeiros does not rule out this outcome given the "buzz" over Apple's upcoming products, especially the highly anticipated release of the iPhone 5.

In that case, the lookback would be the initial price, which would eliminate any future buffer, he said. It would essentially eliminate the lookback as well.

"Having no lookback doesn't make it a bad deal though," Medeiros said.

"Even in light of the upcoming releases, having a 20% upside cap is not prohibitive, frankly. Apple, like the rest of the economy, is going to muddle through a very slow growth over the next 12 months."

Apple will report its earnings for its fiscal third quarter on Tuesday.

Upside risk

But Apple so far this year is up 52%. If the stock were to continue to rally, even at a slower pace, investors in the notes would be penalized.

"How do you know Apple is not going to be up more than 20% in one year?" Doucette said.

"The greater risk is the upside risk," agreed Medeiros. "Apple could be outperforming over the next 12 months. It's not impossible with all the new products they have on the horizon.

"But 20% doesn't take away too much, and in today's market, choosing to have some downside protection is a very prudent decision."

The structurer agreed that the risk is on the upside.

"Because of the high volatility of the stock, the lookback feature may be fairly expensive," he said.

"If it wasn't, my maximum return would be above 20%. To get the 20% maximum return, you need a 10% move. A 10% move is really not much for Apple."

This makes the notes a poor match for a wide range of investors who are bullish or very bullish on Apple, sources said.

Benefits

"I particularly like it on a stock because a stock tends to be more volatile than an index," the structurer said.

"In one month, it can move quite a lot and you can strike an interesting level below the initial price. In that case, you can capture a very decent return."

Medeiros said that the product could make investors who want a long exposure to a stock feel more confident than buying the stock outright.

"I like this feature. My downside basis for the return calculation is a 30-day window. How many times did you get an investment and as soon as you bought it, it went down?

"From a behavioral perspective, I think it's a plus to know that you're entering in a trade today and that the entry point can be adjusted for the next 30 days. It's very attractive, especially for investors who have been burned and have turned skittish as a result for good reasons," he said.

One thing sources agreed on is that the lower the lookback, the better for the investor.

On the downside, for instance, the prospectus showed the potential impact of a low lookback based on its $600 and $1,000 assumptions for the lookback price and initial price, respectively. If Apple shares were to finish at $570, a 43% loss from their initial level, the decline from the lookback would only be 5%. Rather than being long the stock and losing 43% of principal, investors in this example would only lose 5%.

Even if the lookback price were not so low, investors could significantly benefit from it, the structurer said.

He picked a different example with an initial share price of $620 and a flat performance over the course of the year.

"Take an example with no lookback: your return is zero," he said.

"Now introduce the feature and let's say your lookback is $600. Apple ends like it began: at $620. That's flat. But you have a 3.5% gain over the lookback. With the leverage, you end up with a 7% gain from your initial price. Meanwhile, Apple shares have gone nowhere.

"You can really capture significant gains."

J.P. Morgan Securities LLC is the agent.

The notes will price Friday and settle Wednesday.

The Cusip number is 48125VT34.

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