JPMorgan's contingent absolute return autocallables linked to Apple offer unusual payout

By Emma Trincal

New York, Jan. 12 - JPMorgan Chase & Co.'s contingent absolute return autocallable optimization securities due Jan. 28, 2013 linked to Apple Inc. shares intrigued advisers for their counterintuitive payout.

Investors in the notes will make money if the stock goes up or down within a range. But the unusual twist is the slightly bearish bias of the notes. In some cases, the return obtained from a share price decline can be greater than the gain achieved through stock price appreciation.

"The parameters are set within the trading range. But it's strange that you can earn a positive return if the stock falls. It doesn't make a whole bunch of sense," said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

The notes will be called at par plus an annualized call premium of 10% to 13% if the stock closes at or above the initial share price on any quarterly observation date, according to an FWP filing with the Securities and Exchange Commission.

If the notes are not called and the stock finishes at or above the 80% trigger level, the payout at maturity will be par plus the absolute value of the return. If the stock finishes below the trigger level, investors will be fully exposed to the loss.

Bearish bias

"This is very odd," said Lee Kramer, president of Capital Management Analytics.

"You can make more than the premium if the stock goes down as long as the stock falls by more than the premium amount but without hitting the trigger price. If the premium is 13% and your stock drops by 19%, you make more money on the decline than you would on the upside by collecting the coupon," he said.

He added that when the stock falls in the range he so defined, investors participate in the stock performance, while they only earn a fixed call premium if the notes are called.

"This looks like what we call a strangle in options language," said Kramer.

"You collect a premium, but if it moves more in either direction, you can lose money. In that case you're not losing money on the upside. If the stock goes up above the premium, it's an opportunity cost, but it's still a positive return. But on the downside, it's not like your gain is capped at 20%. Once you breach that threshold, you're on the hook for all that decline."

Just right

"I guess you can't be really bullish, otherwise you wouldn't cap your return with the call premium. But you can't be too bearish either and subject yourself to the risk of losing everything," Kramer said.

"It's a Goldilocks bet. You're looking for a happy medium. Your view is that Apple is not going to go up too much but it's not going to go down too much either. You're looking for that just right scenario," he said.

Medeiros agreed that investors are making a range-bound bet. But the "just right" scenario in this case is achievable in his view.

"It's not a narrow range, so I think it's decent," he said.

A comeback

Steve Doucette, financial adviser at Proctor Financial, said that he has invested in these absolute return notes before.

"It's amazing that after all this time we haven't seen much of these absolute return products. Now they're coming back. Obviously the options have become more palatable, probably because the bearish sentiment is turning a little bit more bullish," he said.

Doucette said that the notes could be very attractive for moderately bullish or bearish investors.

"The absolute return makes it very attractive either way," he said.

"You limit your return for a year and collect a premium if the stock stays flat or goes up. And if it falls, you can make money too as long as it doesn't hit the trigger. It works both ways, but it's more bearish than bullish."

Another use of the strategy could be risk reduction.

"It might be a little bit of a hedge for the Apple stockholder. The only time that you really lose is when the stock drops by more than 20%," he said.

"But it's a hedge for a small adjustment. Not for a large adjustment."

Doucette said he experienced firsthand the downside of such products when he invested in similar notes in 2008 and 2009.

"We burst into the barrier on most of [them]. So that's the risk."

UBS Financial Services Inc. and J.P. Morgan Securities LLC are the agents.

The notes will price on Jan. 20 and settle on Jan. 25.

The Cusip number is 48126B582.

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