Morgan Stanley's dual directional notes linked to Apple offer gains when shares fall, rise

By Emma Trincal

New York, March 22 - Morgan Stanley's upcoming 0% dual directional trigger securities due March 2014 linked to the common stock of Apple In. should appeal to investors who are eager to join the Apple bull ride but are uncertain about the direction the stock will take, sources said.

The twin-win structure of the product gives the noteholders a chance to earn positive returns whether the stock appreciates or falls as long as the stock price stays within a range, according to a 424B2 filing with the Securities and Exchange Commission.

If the stock price of Apple finishes above its initial level, the payout at maturity will be par of $10.00 plus the gain, up to a maximum payout of $13.77 to $14.17 per note. In the prospectus, Morgan Stanley uses a cap of 40% for its hypothetical payout graph, but the exact cap will be set at pricing.

If the stock finishes below its initial level but at or above the 75% trigger level, the payout will be par plus the absolute value of the return.

Investors will be fully exposed to the decline if the shares fall beyond the trigger level.

Downside risk

"We don't buy individual stocks, but this is a neat note," said Steve Doucette, financial adviser at Proctor Financial.

"There's so much uncertainty, these dual directional products tend to bring in expected returns that are reasonable. For one thing, it's taking 25% of the decline off the table."

The bullish sentiment around Apple remains high, a sellsider said. The stock price is up nearly 50% so far this year and has grown by six-fold over the past five years.

"My biggest concern is that anything that outperforms that much tends to revert to the means," Doucette said.

More and more investors share the fear of a correction while bulls continue to push the price higher, noted the sellsider.

"The skew of the stock is not as steep as it could be. There's not very much [of] a smile on the stock," he said. "There's a pretty even interest in puts and calls."

Doucette said a bet on Apple at this time poses too much risk.

"For somebody worried about the volatility of Apple shares, that's a good thing, especially since you're getting the absolute value of the decline in that range," said Doucette.

"But is 25% the right amount? That's the tough part.

"A lot of people say 'I missed Apple.' If you think it can still go up 20% annually, then go for it. But to me, the risk of a correction remains too high. You can never tell when Google or another might blow the iPad with their own product."

Twin-win win

Doucette said that dual directional notes are among his favorite structures. He just would not use it on a stock.

"I certainly like this better than a reverse convertible. I don't buy reverse convertibles because you're capping the upside for an unlimited downside," he said.

"With this, you're capping but at a reasonably decent level, and you're also getting this absolute component on the downside, which is very intriguing.

"You only had these absolute return deals in 2008 when the market was nuts. They're coming back right now. While volatility has been falling in the overall market, this stock is pretty volatile, and that's why they're doing it on this particular name."

Decent cap

The sellsider said that unlike the decline in volatility seen in the overall market, the 35% implied volatility of Apple is rather high.

"The terms of this deal are good, but given the volatility of the stock, I'm not surprised," he said.

"A 35% implied [volatility] is not enormous, but for a stock that has been performing so well, it's still a good level of volatility. It gives you some juice to work on to create a good product."

The 40% cap is "decent," this sellsider said.

"But with Apple, you never know. It could be hit in a couple of years."

However, the deal should be appealing to investors for the absolute return performance.

"We see a lot of interest in this market for those dual directional payoffs," he said.

Apple bull

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said he is bullish on the stock and comfortable with the maximum return offered.

"I like this deal. I'm a big fan of Apple," he said.

"I don't mind the cap in this scenario because 40% in two years is a generous level.

"I believe they have a strong pipeline and a solid growth potential for the next couple of years. I wouldn't say a correction by more than 25% is impossible. But I think there's enough positive momentum with Apple to insulate you from that risk."

Rich calls

Mark Sebastian, chief operating officer of Option Pit, a Chicago-based options advisory firm, said that call interest in the stock is still very high, which allowed the issuer to offer a high cap.

"It's not bad. At its face, it sounds interesting," he said.

"It looks like they're selling a straddle. They're selling out-of-the-money calls, and they're selling out-of-the-money puts."

Shorting a straddle is the simultaneous sale of a put and a call on the same underlying.

"In addition to that, they're buying a lot of further out-of-the-money puts."

"The stock itself is not that volatile," he added, "but the calls are overbought, so they get a rich premium from selling the calls, which is how they can offer 20% a year on the upside.

"The catch with this structured note is that if Apple drops more than 25%, then you lose."

Morgan Stanley & Co. LLC is the agent, and Morgan Stanley Smith Barney LLC will handle distribution.

The Cusip number is 61760T587.

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