JPMorgan's twin-win notes linked to Brent crude oil are for investors in doubt about direction

By Emma Trincal

New York, March 27 - JPMorgan Chase & Co.'s 0% dual directional notes due April 11, 2013 linked to the first nearby month futures contract for Brent crude oil give undecided investors a chance to capitalize on both a rise and a fall of the price of oil. The catch is that price moves must be within a range in order for investors to outperform the underlying contract.

If the final contract price is greater than or equal to the initial contract price, the payout at maturity will be par plus the contract return, subject to a maximum return of at least 16.25%. The exact cap will be set at pricing.

If the final contract price is less than the initial price by up to 25%, the payout will be par plus the absolute value of the contract return, according to an FWP filing with the Securities and Exchange Commission.

If the final contract price is less than the initial price by more than 25%, the payout will be par plus the contract return. Investors will be fully exposed to losses.

Risk/reward profile

Lee Kramer, president of Capital Management Analytics, said the notes offer a good risk/return trade-off. He noted that investors have a chance to earn the exact appreciation of the contract up to 16.25%. On the downside, they have the potential to generate a profit of up to 25% even if the contract declines as long as the decline does not exceed 25%.

"It's an interesting trade," he said.

"Oil could continue to be volatile. You can make money either direction. It gives you a wide band. The probabilities of making money are pretty high."

He also noted that the point-to-point payout is a plus for investors.

"These are European-style options they're mimicking. What matters is the final price. It's a good feature. The probabilities of making a gain are pretty high given the absolute value.

"And the odds of oil dropping by more than 25% are low.

"The cap gives you a decent upside potential."

But Kramer did not minimize the risk. Once the downside barrier is breached, investors lose the benefit of the contingent protection.

"It's speculative, no question about it," he said.

Call spread, put spread

The most appealing feature of those dual directional notes, sometimes called "twin-win," is the opportunity to make money even when the underlying goes down as far as a certain point, Kramer said.

He explained how the issuer put together the product using options trades. He said the product was built around a "three-leg trade."

The first one was to buy a call spread; the second, the purchase of a put spread; and finally the sale of some puts to finance those two long positions, according to Kramer.

He assumed a hypothetical initial price of 100, a downside threshold at 75 for the 25% contingent buffer amount and a 116.25 price representing the maximum return on the upside.

The capped upside is the equivalent of the issuer purchasing a call spread.

"They bought an at-the-money call and sold an out-of-the-money call at a 116.25 strike," he said. "This gives them the upside participation up to the cap."

To replicate the downside, which transforms a price decline of less than 25% into a gain, Kramer said that the issuer bought a put spread.

"They bought an at-the-money put while selling an out-of-the money put at a 75 strike," he said.

"The long put gives investors the positive return for each dollar of decline from 100 to 75.

"With the short put, the game is over when you hit the strike."

The challenge of buying the call spread and the put spread is cost, he explained.

"This is why a third leg of this trade must be the issuer selling out-of-the-money puts just to finance the purchase of the call spread and put spread," he said.

Cap issue

Despite the appeal of the absolute value payout, some investors prefer fewer bells and whistles, especially when they don't see any reason to be overly bearish.

"Our problem with this is the cap," a financial adviser said.

"Our philosophy is that if you want to make a bullish bet on oil, just go long oil and get your exposure that way.

"If you buy oil, you can pick your exit point and you take all the returns above 16.25%."

For skittish investors concerned about the downside risk, the notes "make sense," he said.

"I see why certain clients would find that product attractive.

"They may have high conviction in their mind, but they may not be willing to do what it takes to go long on their own," he said.

But the 16.25% cap on the upside is too much of a price to pay for the protection, he said.

"I don't think in the near term there is a ton of downside. What would bring the price of oil down would be an economic slowdown in the U.S., and it doesn't seem to be in the cards," he said.

Wide range

Matthew Bradbard, branch manager and managed futures specialist at RCM Asset Management, said that he does not rule out a correction. But he added that future price moves should be contained within the band offered in the notes.

"Oil has just rallied by 35% since October, so obviously it can drop," he said.

"But I think it's fine. I see it trading within a 15% trading range up and down within the year."

He noted that investors have more than just protection on the downside above the 75% barrier.

"They could make a profit in that range. Sounds good to me," he said.

Brent oil contracts for settlement on May 12 were trading at $125.26 a barrel on Tuesday.

The notes (Cusip: 48125VUD0) will price Friday and settle April 4.

J.P. Morgan Securities LLC is the agent.

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