JPMorgan’s bearish return notes on Nasdaq offer hedge, but the cap reduces trade’s appeal

By Emma Trincal

New York, Feb. 19 – JPMorgan Chase Financial Co. LLC’s capped bearish return notes due March 28, 2022 linked to the Nasdaq-100 index could be used to hedge a market decline, a portfolio manager said.

If the index finishes negative, the payout at maturity will be par plus 1% for every 1% that the index declines, subject to a maximum return of 25%, according to a 424B2 filed with the Securities and Exchange Commission.

If the index return is positive, investors will lose 1% for each 1% that the index increases.

Short squeeze

“It’s an interesting strategy. We don’t see many notes like that,” said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

Investors buying the notes could use it as a hedge in a down market, he added.

However, he did not like the 25% cap limiting the gains in a bear market.

“I’m trying to figure out what could be the advantage of this versus shorting QQQ,” he said.

The Invesco QQQ trust listed on the Nasdaq under the ticker “QQQ” is an exchange-traded fund widely used to track the performance of the Nasdaq-100 index.

“The only advantage of the note is that you can’t lose more than 100%. Your losses are unlimited when you short a security as we’ve seen recently with GameStop,” he said.

Last month, hedge funds with short positions on video game retailer GameStop were hit hard by heavy call buying on the part of retail investors influenced by internet website WallStreetBets. The share price skyrocketed, forcing short sellers to buy back at a higher price the stock they had already borrowed and sold.

The squeeze, which was not limited to GameStop, illustrated the amount of risk short sellers face when prices go up.

Tradeoff

“OK, so the note limits your risk to 100%. But it also caps your gains to 25% in a bear market,” he said.

“I’m not sure I like the tradeoff. I think that’s giving up a lot.

“What are the odds the index would double in 13 months versus the chances of a 25% drop?”

Mathematically, the chances of a market going up 100% are the same as a 50% drop, he noted.

“I think to be fair they should give you a 50% cap.”

The note was not priced that way. But Kaplan said eliminating the cap and protecting losses to up to 100% of principal could be done.

“If you don’t want a pure short exposure to QQQ, you can replicate the structure synthetically. I think you could get better terms and probably at a lower cost,” he said.

Killing the cap

He offered more details.

First, investors may short the ETF, which would remove the cap.

Second, they could limit the losses to 100%, replicating the risk exposure of the notes.

The ETF was trading at $330. He suggested buying a “far out-of-the money” call at a 660 strike, which places the strike level 100% higher than the current (at-the-money) price.

A call is out-of-the-money when the current price is below the strike and “far” out-of-the-money when the gap between price and strike is significant.

Inversely when the strike is below the price, the “in-the-money” call option is winning.

“The call is so far out-of-the-money, it would be a cheap option to buy,” he said.

The purpose of buying the call option is to partially hedge the short position. In this case, the hedge works for any price rising above the 660 strike thus limiting the risk to 100%.

“If QQQ goes up, you lose on the short. But if it’s up more than 100%, you gain,” he said.

As the call position is now “making money” any loss created by the short position is now offset dollar for dollar by the call, which is now “in-the-money.”

From that standpoint, the synthetic trade maintains the same market risk exposure as the notes while eliminating the cap.

No cap, less risk

Kaplan said the synthetic position could also be improved. For instance, the risk could be cut in half.

This would involve buying the call at a strike price situated 50% above the at-the-money price based on a share price of $334 during Friday morning session.

A 50% increase in the price would set the call strike at approximately 500.

Looking at a call option contract expiring on June 17, 2022 – three months later than the maturity date of the notes – he found in the options chain a midpoint of the bid/ask spread at $2.78.

“If you want to buy it you can probably bid on it at $2.85,” he said.

The cost per contract as a percentage of the share price would then be 0.85%.

The short sale part of the trade would not be modified.

Kaplan gave a rough estimate of its cost.

Adding things up

Short sellers must borrow the stock typically from their broker since they don’t own it. They must also pay the dividend.

The Invesco QQQ Trust yields 0.5%.

“The index is very liquid. It’s not a hard-to-borrow asset,” he said.

As a result, he estimated the borrowing cost at approximately 0.15%.

The estimated cost for the short sale would then be 0.65% to which must be added the 0.85% call premium for a total cost of approximately 1.5%.

While it may seem expensive, Kaplan said the synthetic trade offers more benefits than the notes.

“It’s a 16-month deal. You’re protected 50% over a longer time. And if we’re in a bear market, your return is no longer capped at 25%,” he said.

“Sounds like a much better deal to me.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will price on Feb. 23 and will settle on Feb. 26.

The Cusip number is 48132R5Q9.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.