JPMorgan’s $1 million bearish knock-out on SPDR S&P 500 ETF is ‘no magic,’ structurer says

By Emma Trincal

New York, Sept. 27 – JPMorgan Chase Financial Co. LLC’s $1 million of 0% bearish knock-out notes due Sept. 25, 2024 linked to the SPDR S&P 500 ETF Trust are aimed at investors who anticipate a declining market in the next 12 months. While some of the terms appeared exceptionally attractive, two structurers deconstructed the pricing, explaining how the issuer had been able to “put it all together.”

A knock-out event will occur if the ETF closes below 70% of its 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 plus 14.35%.

If a knock-out event does not occur and the ETF declines, the payout will be par plus the absolute value of the ETF return.

If a knock-out event does not occur and ETF finishes flat or positive, the payout will be par.

Three possibilities

A structurer summarized the three possible outcomes:

• The barrier is breached on any trading day triggering the 14.35% payment at maturity;

• The barrier is never breached, and the ETF finishes negative, enabling investors to gain up to 30% from the one-to-one inverse participation; or

•∙The barrier is never breached, and the ETF finishes positive: noteholders get their principal back with no gain.

The first two scenarios are preferable and require the market to go down at some point.

“It looks like a very customized bearish strategy. The pricing is a function of rates being where they are,” this structurer said.

No free lunch

As with any other note, the terms are essentially a function of market expectations.

“There’s a decent probability that the market will be higher in one year, which is not the best scenario for the bear buying the note. That’s how the options market is pricing it.

“There’s no magic, really. It’s a play on your mind. You may think: ‘wow! Worst-case scenario, I get my money back in one year. I haven’t made any money, but I haven’t lost anything either.

“That’s exactly what’s the most likely to happen. Options prices are based on probabilities of distribution. What’s the most appealing outcome is not going to be the most probable.

“JPMorgan is not in the business of giving you free money. The pricing here is nothing special,” the structurer said.

Cheap option

A second structurer explained that the cost of pricing the notes was relatively low based on a review of the various options used in the model.

“It’s a principal-protected note that’s attached to a super cheap option: a long position on a down-and-out put with an American knock-out barrier,” he said.

A down-and-out put simply means that if the ETF falls below the 70% knock-out barrier level at any time during the life, the option expires. However, the option does not expire worthless since a 14.35% rebate is offered, he noted.

“The investor needs the market to go down to make money but if it goes down too much, they will get capped out at 14.35%.

“Say you breach the 70% barrier at one point and the ETF finishes down 29.99%. You’ll get paid 14.35%, which is less than half of what you would get from the absolute return,” he said.

Finally, the note pays no income, which also decreases the cost of the option.

“The position is cheap because it can be bought by the interest forgone on one-year’s interest,” this second structurer concluded.

A win for bears

For bears, however, who base their investment decisions on their own convictions, the payout of the note was opportune.

“It works out well,” said a financial adviser.

“The chance of getting 14.35% is pretty high. On a daily basis especially, you can certainly hit that minus 30% cutoff.

“Given the normal volatility plus the fact that the market is more volatile than normal, you’re on track to get the 14% return after one year, which is quite nice,” he said.

Investors would be better off if the ETF never breached the 70% barrier during the life of the note, and if the price finished between 14.35% and the barrier level, ideally near the barrier threshold at around 28%, 29% or even 30%, he said.

“You would get much more than 14.35% but the probabilities for this to happen are pretty low in my view. I don’t see the market staying at or above the 70% level every single trading day for the next 12 months. So, you have a high chance of success of getting the fixed payout.”

The note could be employed for other strategies than a pure bearish bet.

“Even a bull could use it as a hedge. Alternatively, it could be used as a supplement in a Treasury portfolio,” he said.

“I like this kind of note.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes settled on Tuesday.

The Cusip number is 48134A2N4.

The fee is 2%.

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