UBS' autocallables tied to Starbucks give pause to advisers because stock is high, volatile

By Emma Trincal

New York, July 13 - UBS AG, London Branch's upcoming trigger phoenix autocallable optimization securities due July 19, 2012 linked to the common stock of Starbucks Corp. may not compensate investors sufficiently for the risk associated with a volatile stock that is already trading near its 52-week high, making it vulnerable to a correction.

If the price of Starbucks stock closes at or above the trigger price - 80% of the initial share price - on a quarterly observation date, the issuer will pay a contingent coupon of 10% to 13% per year for that quarter, according to an FWP filing with the Securities and Exchange Commission.

Otherwise, no coupon will be paid for that quarter. The exact rate will be set at pricing.

If the share price is greater than or equal to the initial price on any of the observation dates, the notes will be called at par of $10 plus the contingent coupon.

If the notes are not called and the Starbucks share price finishes at or above the trigger price, the payout at maturity will be par plus the contingent coupon. Otherwise, investors will be exposed to the share price decline.

Overvalued

Andrew Valentine Pool, main trader at Regatta Research & Money Management, pointed to the bullish momentum around the stock and said that the name is already overbought.

The share price, which closed at $39.58 (Nasdaq: SBUX) on Wednesday, is about $1.50 below its 52-week high.

"We would probably not get this. The stock has grown immensely since September, from $24 to $40," Pool said.

Year to date, the stock has moved up 23%.

Pool conceded that some of the structure features are attractive.

"I like the idea that it can go down roughly 20% without a loss of principal.

"I also like the idea that even if it's down, providing you stay in that range, you can still collect the coupon.

"But we don't see the stock going much more than $40 as it's been climbing all the way up so far," he said.

Not defensive

Another problem with Starbucks, Pool explained, is its vulnerability to an economic downturn.

"Starbucks is the epidemic of higher priced coffee. If the economy slows down, Starbucks is definitely going to be hit," he said.

As a rule, Pool said he preferreds to invest in notes linked to an index or an exchange-traded fund.

"We're not very big on one stock. With a note tied to a stock, all you need is an idiot getting caught in a scandal and it doesn't matter how good your coffee is," he said.

More downside protection would help, Pool added.

"I like the structure except for the 20% protection. I would want more," he said.

"I see a resistance around the April 10 level of last year, at around $25.

"With a 30% protection, I would feel much more comfortable."

European option

Lee Kramer, financial adviser at Capital Management Analytics, said that there are pros and cons with the structure when compared to a reverse convertible.

"It's very similar except that here they determine whether you get knocked in, whether you're susceptible to a loss, at maturity and not during the term. It's like a European option, and it's better for the investor than a reverse convertible when they look at it any time," he said.

"Now, looking at the quarterly interest, if your stock is down by more than 20%, you don't get the interest with this product. That's not the case with a reverse convertible, which will pay you a coupon regardless of the stock's performance."

Bad probabilities

Kramer's major objection to this product is the risk brought on by the underlying stock based on the volatility around the name and the high cost of the underlying options.

"I ran a basic options probability model and found that you have a 28% probability to see this stock fall by more than 20% at maturity," he said.

"A 28% chance of losing 20% or more of your principal is a lot. And what you're getting in exchange for that risk is an interest payment.

"I just don't like the risk/reward on this one. If you're really bullish on the stock, you may want to own the stock."

High implied

The high probability of losses is derived from the high volatility of the stock, he explained.

"This is a pretty volatile stock. It has a 1.26 beta, which means that its volatility is 26% greater than the overall market," he said.

"The options are pretty expensive. Based on that, you can develop your own option strategy as an alternative."

Kramer pointed to the "wide gap" between the implied volatility of the stock, which is 30%, and the historical volatility, 22%.

Historical volatility measures the volatility experienced by the stock, and implied volatility represents the market's expectation for the future volatility of a stock.

The higher the implied volatility is, the more expensive the cost of the option is and the greater the risk, he explained.

"There is momentum around this stock, and you're susceptible to risk if the momentum stops," he said.

"Either big institutions like pensions are excited by the name and are bidding up on calls or you have a lot of bulls sitting on the stock who want to buy insurance on it and they're buying puts.

"I think it's probably the second scenario that explains why the implied is so high relative to the historical."

Risk versus reward

"When the implied is high and the options expensive, it's [risky]. I would expect either a higher coupon or more protection to the downside," he said.

"It doesn't seem like the coupon is very high to compensate me for taking that risk.

"And on the downside, I would expect a trigger at 25% or 30% below what the stock is trading at now."

The notes (Cusip: 90267X783) are expected to price Friday and settle July 20.

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