JPMorgan's 7%-9% trigger yield notes tied to Chesapeake create income for neutral investors

By Emma Trincal

New York, July 22 - JPMorgan Chase & Co.'s 7% to 9% trigger yield optimization notes due July 27, 2012 linked to the common stock of Chesapeake Energy Corp. replicate an option strategy combining the selling of a put and the selling of a call.

It is designed for investors seeking income on the view that the stock will trade sideways, said Ryan Detrick, senior equity analyst at Schaeffer's Investment Research.

The face amount of each note will be equal to the initial share price of Chesapeake Energy stock, according to an FWP filing with the Securities and Exchange Commission.

Interest will be payable monthly.

The payout at maturity will be par in cash unless the final price of Chesapeake Energy stock is less than 75% of the initial share price, in which case investors will receive one Chesapeake Energy share per note.

Investors believe that the stock is not likely to end below the trigger price, according to the prospectus.

The risk they take in exchange for a coupon is to receive at maturity shares of Chesapeake that may be worth less than their principal amount, the prospectus stated.

Selling a put

"It's a neutral to bullish strategy. You don't really care if the stock goes up, as you would make the same amount. You just want it to close above that strike of 75% of the initial level. Basically how much it moves is irrelevant as long as it doesn't hit the trigger," said Detrick.

Detrick explained that the trigger price was the equivalent of a put strike.

"The investor sells a put when he's confident the stock won't go down too much. He can keep his premium when the stock closes above the strike and that's what he's betting on," he said.

The stock on Friday closed at $34.00.

The trigger price would be 25% less, or approximately $25, said Detrick.

"The idea behind this strategy is that if the stock trades range bound, if it goes nowhere, you can still profit from that," he said.

Detrick said that the stock has not hit the trigger price of $25.00 per share since late last year.

"The odds of dropping by 25% on a one-year period are always there," he said. "But this is not the most volatile stock in the world. And there's a lot of support."

In addition, Chesapeake Energy is a producer of oil and gas, a commodity sector that has seen a recent rebound, Detrick said.

"Energy stocks have shown some strength lately. It's a sector that has done well. In fact energy stocks are starting to lead the actual commodity. People are loading up on commodity stocks in general. These are favorable factors that add more support for the stock," he said.

Selling a call

Another structural aspect of the note is that it limits the upside to the coupon payment.

The prospectus explained that the coupon will be paid "regardless of the performance" of the stock.

Such payment is the equivalent of a premium received by an investor for selling a call with a strike price of 108%, said Detrick, assuming an 8% coupon.

"Your coupon is your premium for selling the call. This is an income-driven strategy. You don't anticipate a huge upside for the stock," he said.

"If you're really a bull, if you think the stock can go up to $50, obviously you wouldn't buy this note. Instead, you would buy the stock or a call.

"The stock is near the top of its range. It peaked at $36 in February. It has had a very good run. It's up 33% this year. You're not far away from its resistance level, so the odds of more gains are slim.

"This strategy makes sense.

It's a nice way to create income on a stock that doesn't move a lot or won't go significantly higher.

Calls and puts

There are no one-year options contracts on the stock, according to Detrick, citing January 2012 and January 2013 contracts.

The top open interest positions are for the January 2012 options contracts, with 61,000 puts with a 30 strike and 39,000 with a 35 strike, he said.

A 30 put strike indicates that the put buyer anticipates that the stock will decline from its current price to below $30 at expiration date.

A 35 call strike illustrates a view in which the call buyer sees the stock rising above the price of $35.

For this six-month period, the market interest is more bearish as shown by the number of puts relative to the calls, he said.

But the opposite market sentiment emerges for longer-dated contracts, which reveal a volume of calls (137,000 open contracts) largely greater than the number of puts (96,000).

"I think it's clear that the bearish sentiment is more short-term. On a longer period, bullishness prevails," said Detrick.

The notes (Cusip: 46636T309) are expected to settle Wednesday.

UBS Financial Services Inc. and J.P. Morgan Securities LLC are the agents.

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