JPMorgan’s $10 million digitals on S&P show volatility play for range bound view

By Emma Trincal

New York, June 8 – JPMorgan Chase Financial Co. LLC’s $10 million of 0% digital knock-out notes due June 18, 2024 linked to the S&P 500 index present a relatively innovative structure for investors betting on a range bound market. While the payout was attractive, advisers objected to the limited chances of earning it due to some of the structural aspects of the note, in particular the daily observation of a dual barrier.

A knock-out event will occur if the index closes above its upper barrier, 110% of the initial level, or below its lower barrier, 80% of the initial level, on any trading day during the life of the notes, according to a 424B2 filing with the Securities and Exchange Commission.

If a knock-out event occurs, the payout at maturity will be par.

If a knock-out event has not occurred, the payout will be par plus 22%.

Novel

“I haven’t seen that before. It’s definitely different,” said Steve Doucette, financial adviser at Proctor Financial.

“You could easily be up more than 10%. The market is moving so fast.”

He noted that the S&P 500 index has already gained 9.6% in the past three months.

A price move beyond the lower barrier was also possible.

“It could really go either way – up more than 10% or down more than 20% – either one of these are possible,” he added.

“It’s a gamble. It’s a play on volatility when volatility is pretty low. You’re betting that the S&P will stay within a range, but it may not. Since you look at it every day, the price could hit one of these barriers pretty quickly.”

The CBOE Volatility index has fallen to its lowest point since January 2020 at 13.65. The so-called “VIX,” which measures the short-term implied volatility of S&P 500 index options, has dropped 56% from its most recent high of 30.81 during the regional bank crisis in mid-March.

Bearish tilt

“You get the principal protection. That’s your safety factor. Regardless of what happens with the market, you’re going to get your money back,” he said.

“If you’re right, if the market stays within the range, you get paid. Twenty-two percent in one year is not a bad return.”

Doucette said that his only concern with the note would be to miss out on the upside.

The note is built based on a “bearish bias” by virtue of the fact that the range is twice wider on the downside than on the upside, he said.

Moreover, investors are more likely to outperform on the downside.

“If you breach the barrier on the downside, it’s not a bad thing. You get your money back and the market could still be down at maturity,” he said.

Fear of missing out

On the other hand, a gain above the upper barrier may cause the note to underperform since investors gain nothing at maturity while the index could finish higher, he added.

The “fear of missing out” was the main drawback, he said.

“Issuers come up with interesting ideas. This one is a little bit tricky because you hope this thing will stay range bound. But how likely is it to stay within that range?” he said.

The daily monitoring of the barriers reduced the odds of getting paid, he concluded.

“That’s the scary part. It could hit any day.

“And that’s probably why I wouldn’t touch this note,” he said.

Barrier risk

Matt Medeiros, president and chief executive at the Institute for Wealth Management, said he did not like the risk-return of the note, stressing that the principal protection had not totally eliminated the risk. He defined the risk as the possibility of not earning any payout at maturity.

“I do like the fact that there is a 100% principal protection.

“But if the chances of making money are slim, you would expect the protection. My point is that I’m not sold on the return component of this note,” he said.

Medeiros said that the probabilities for the S&P 500 index to rise above 10% or to drop more than 20% at any time during the course of one year were high.

“The odds are great in large part because it’s an American barrier,” he said.

The term “American” designates barriers that can be observed during the life of a note rather than at maturity.

“It is a dual directional note in a way, but it doesn’t work to your benefit.”

A breach of the barrier, either upward or downward on any trading day, would eliminate all chances of getting a positive return from the note.

“You don’t get the 22%. You don’t get anything except your principal back. It’s an opportunity cost. That would be my concern,” he said.

For Medeiros, the chances of a 10% or more index gain over the period were reasonably high.

“The market is up right now. I don’t anticipate the momentum to continue at the same rate. But I wouldn’t be surprised if it went up more than 10% within the next 12 months,” he said.

Dangerous bullet

The tenor was short. But the bullet notes and the terms created some liquidity risk, he added.

“Let’s say that at the end of the month, the quant hedge funds reallocate their portfolios pushing the market 11% higher than what it is today. The market may realize the reason for the surge and normalize. But you’ve lost your 22% return. Meanwhile you have to hold the notes another 11 months with no chance of getting out. There is no autocall. You’re stuck in a note that’s worthless and as such you can’t sell it on the secondary.

“In that scenario, who cares about the downside protection? There is no upside,” he said.

In conclusion, Medeiros said he would not consider the notes.

“This is not an easy note to explain to a client. It would think it was designed for institutions, although it may or may not be the case,” he said.

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes settled on Wednesday.

The Cusip number is 48133XLZ7.

The fee is 1%, according to the prospectus.

© 2015 Prospect News.
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