Bank of Montreal's buffered notes on Russell 2000 ETF offer cost-efficiency versus options

By Emma Trincal

New York, Dec. 5 - Joe Bell, senior equity analyst at Schaeffer's Investment Research, compared Bank of Montreal's 0% buffered bullish enhanced return notes due Dec. 30, 2013 linked to the iShares Russell 2000 index fund to an equivalent options strategy and found that the notes are less expensive in upfront costs for retail investors even though both trades have their respective pros and cons.

The payout at maturity will be par plus double any gain in the fund, up to a maximum payout of $1,260 to $1,320 for each $1,000 principal amount, according to a 424B2 filing with the Securities and Exchange Commission.

The exact cap will be set at pricing.

Investors will receive par if the fund falls by up to 10% and will lose 1% for each 1% decline beyond 10%.

Bell, in order to replicate a similar risk-reward profile with options, made the following assumptions:

• The iShares Russell 2000 index exchange-traded fund would be priced at $74 per share;

• The issuer would opt for a cap of $1,320 for each $1,000 principal amount, or 32% above the initial price;

• The ETF would only need to increase by 16% over the period in order for the investor to reach the maximum return given leverage factor of two;

• As a result, the cap would be at a share price of $85.84 per share, or 16% above the initial price of $74; and

• The 10% buffer below $74 would represent a $66.60 price.

First, Bell replicated the upside combining a covered call and a bullish debit spread.

Covered call for cap

He described the covered call as follow:

"I'm buying 100 shares of the ETF at $74 a share for a total of $7,400. I have to do that because you can only trade options with one contract and one contract controls 100 shares of stock," he said.

"I'm also selling one December 2013 85.84 strike call.

Bell explained that December 2013 options do not exist for this ETF. As a result, he created a "FLEX option" with non-standard strikes to get an exact equivalent to the note.

FLexible EXchange Options (FLEX options) are customized equity and equity index options available at the Chicago Board Options Exchange.

The first leg of the upside replication of the structure using options - which is the covered call - creates the cap, Bell explained.

By selling the call at an $85.84 strike price, which is 16% above the initial price, investors give up any upside above the strike, capping de facto their upside at 16%, which is the equivalent of the 32% cap after leverage.

Leverage

The second part of the upside replication is centered on the leverage and is accomplished using an option strategy called bullish debit spread.

Bell defined a bullish debit spread as the combination of buying an at-the-money call and selling an out-of-the-money call.

In this scenario, the strategy consists of buying one December 2013 74 strike call while selling a December 2013 85.84 strike call.

The numbers 74 and 85.84 following the expiration dates of each contract refer to the respective strike prices.

The purchased call is "at-the-money" because its strike price of $74 is the same as the current stock price as the options are bought at the initial time.

"If at expiration, the stock closes for instance at $80 per share, I've gained $6 on my actual long stock position," said Bell.

"By holding a 74 strike call, the intrinsic value of my call is now $6."

The intrinsic value of an option is the difference between the price of the security and the price of the option.

"My Dec. 74 call represents the right to purchase the stock at $74 a share. So, it's worth $6 if the stock trades at $80.

"You get the same value twice - here $6 twice - from the appreciation of the stock price and from the intrinsic value of the call.

"That's how you achieve leverage," he said.

Buffer

On the downside, the replication of the 10% buffer is accomplished through the purchase and the sale of two puts with different strike prices, he said.

In order to replicate the protection and also the risk beyond a 10% decline, an investor would buy a December 2013 put at a 74 strike while selling a put of the same expiration date but at a 66.60 strike.

"The combination of buying at-the-money put and selling an out-of-the-money put is commonly referred to as a "bearish debit spread."

"Buying the put is what allows you to keep the 10% if the stock declines by 10% or anything less than 10%," he said.

"By selling the put, you get some proceeds. Any money you lose on the downside from the ETF shares between $74 and $66.66, you gain from the purchased 74 put. One offsets the other.

"The put gains value as the stock goes down, so you lose money on your stock but you gain on your put. As a result, you break even until the stock reaches $66.66," he said.

More money upfront

Based on a theoretical value using the FLEX options, Bell priced the options as follows:

• The cost of buying the 100 shares of the ETFs was $7,400;

• The net cost for all four options positions was $340. Those positions included buying one 74 call, selling two 85.84 calls, buying one 74 put and selling one 66.66 put; and

• The total cost to initiate an options contract equivalent to the notes was $7,740.

"Obviously having to put out $7,400 is much more expensive than buying the notes for as little as $1, 000," he said.

"It's essentially because you must buy at least an option contract, which is 100 shares.

"Options come at a cost. But you also do not take on any credit risk like you would if you bought this note.

"You also pocket dividends on the ETF, which you would not on the note," he said.

Bell noted that when using options, replicating a leveraged buffered note was more expensive than mimicking other types of structures, such as reverse convertibles for instance.

"This particular structure is going to cost you more if you do it with options because you can't use margins," he said.

"There's no margin because you're not short any options. You use margin when you're net short. Here, you're net long. All short options - the 66.66 put and the two 74 calls - are hedged by stock positions.

"The position doesn't require margin. You've paid out of debit."

"This is one other reason why this trade is so expensive. It cost you more money with the options but you can eventually make more," he said.

BMO Capital Markets Corp. is the agent.

The notes will price on Dec. 22 and settle on Dec. 30.

The Cusip is 06366QM38.

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