Morgan Stanley’s enhanced trigger jump securities linked to oil show good timing, trader says

By Emma Trincal

New York, April 20 – Morgan Stanley Finance LLC’s 0% enhanced trigger jump securities due May 9, 2019 linked to West Texas Intermediate light sweet crude oil futures contracts may be a helpful instrument for a trader trying to capture the upside in oil prices before the rally reverts into a bear market, said Steven Jon Kaplan, founder and portfolio manager at TrueContrarian Investments.

“A note is worthwhile if you can’t easily simulate it with a combination of long and short positions and options. It’s also valuable if it fits your market view,” he said.

Kaplan trades the markets long and short. He does not necessarily buy structured notes. But he looked at this product because the time horizon and the asset class met his interest.

His approach is contrarian and he has been buying energy stocks well ahead of the current jump in oil prices. But in some occasions, he found that a structured note may be a good alternative to the more traditional long and short positions in stocks, exchange-traded funds and options.

The notes are guaranteed by Morgan Stanley, according to a 424B2 filing with the Securities and Exchange Commission.

If the final price is at least 70% of the initial price, the payout at maturity will be par plus 11.9%. Otherwise, investors will be fully exposed to the decline in the price of oil.

Timing

“The timeframe, one-year, is favorable here. In May 2019, I believe that oil will be more in the range of a relatively high point,” he said.

Kaplan observed that historically oil prices tend to peak about a year after the Russell 2000 index reaches a high.

The small-cap index for instance peaked in July 2007, 12 months ahead of crude oil’s all-time high.

This time the Russell reached its highest point in January.

“It may not be exactly a perfect timing. Oil prices a year from now may already be on the way down. But you would end up OK unless crude prices drop 30%, which I don’t see happening.”

There is still more room and time for oil prices to rise.

“Oil has rallied but we’re not anywhere near the highs of 2007,” he said.

In the headlines

Since the beginning of February, WTI oil futures contracts have seen their prices rise by more than 16%.

Kaplan, who was long energy stocks not long ago when the sector was unpopular, has closed some of his positions to capture some of his gains.

“I’ve noticed that when notes come out things tend to have gone up in price already,” he said.

“I’m not sure why. I guess oil is up and people get excited.”

Following the crowd is the opposite of Kaplan’s investment philosophy. Instead he tends to “buy the fear” and “sell the greed.”

Still, he found the notes interesting because the strategy fit his own timeframe.

“The entry is not ideal but the timing is reasonably good,” he said.

Wins probabilities

In addition, the structure offered some specific advantages.

“I’d rather start a note at a lower point. But there is a potential for gains that’s attractive. At 11.9% you don’t have a huge upside potential, but if the market drops 30%, you do outperform in a very meaningful way. They cap your upside but your probabilities of making money are great given the wide downside range. If the market transitions at the time of maturity and starts trading down, it can be very favorable.”

Kaplan is bearish on equity markets but not for this year. He expects a recession first. Even if a bear market began earlier next year, commodities in the inflationary environment are likely to see ups-and-downs without necessarily showing a big drawdown when the notes mature.

“I think you’ll be OK with a 30% protection on the downside. To have a lower point in May 2019 is pretty unlikely in my opinion,” he said.

“Commodities will follow stock prices but not right away.”

Access to complex options

Kaplan said he also likes the notes for what they allowed investors to do versus using an option strategy.

“Can you do better using stocks, futures and options? Or does the note offer a unique value? In this case, I think the note is giving you something that would be hard to synthetize on your own,” he said.

An apparently simple – but incomplete – way to replicate the structure would be to be long the futures contracts, sell a call that would cap the upside, buy an at-the-money put for the protection and sell a put 30% below the at-the-money price, he explained.

“It wouldn’t quite work though,” he said.

An option is “at-the-money” if the strike price is the same as the current price.

“The issuer must be getting an exciting call premium to be able to price it at 11.9%. If you want to try and replicate this, you have to see what your net is, how much you get from selling the options versus buying them,” he said.

“I can already see that it’s not that easy to mimic.”

OTC derivatives eyed

For instance, he asked, how to ensure that investors get the digital return even if prices are negative but above the barrier.

“That’s a little bit more complicated than selling an at-the-money call and doing a put spread,” he noted.

A put spread is when the same amount of puts are bought and sold simultaneously.

Kaplan said he identified in the notes some characteristics, which are different and in some cases advantageous when compared to the use of options.

He attributed those characteristics to the use by issuers of over-the-counter derivatives, which come in a wide range of exotic options. Also OTC contracts offer more flexibility in the way they are traded even if on the flip side they show less liquidity than the options listed on an exchange.

“But if you’re going to give up liquidity anyway you might as well go with the notes,” he said.

One advantage was the digital option, which creates the “jump” at the barrier level.

“It’s giving you the upside even if the price drops, which would be much harder to simulate with listed options,” he said.

Another important difference was the knock-out barrier used with the notes. Such barrier is a “down-and-out” put option.” Once the barrier (or strike) is breached, the option ceases to exist.

Exotic barrier

Kaplan said that in his “back of the envelope” replication, the use of a long put at 100 and short put at 70 would not mimic the knock-out barrier featured in the note. Instead, the put spread strategy would generate a hard protection in the form of a 30% buffer. Investors would “keep” the first 30% in price decline. They would begin to take losses only beyond that level.

“It’s more attractive than the barrier. But it’s also more expensive.

“It looks like it wouldn’t be so easy to mimic the barrier. Less attractive than a buffer, the barrier is probably also much cheaper. That’s perhaps how they’re able to come up with this generous amount of protection.

That’s also how they can do what they call the ‘jump’ on the upside.

“You’re taking somewhat more risk if you’re having a big drop.

“But given the history of crude oil, it’s unlikely,” he said.

Last days

Timing is an essential aspect of Kaplan’s trading strategy, which in general tends to be more long-term oriented and focuses on value.

He predicts a bear market in stocks by the end of next year or in 2020.

Instead of looking for geopolitical reasons behind the current oil rally, what is happening with the bid on oil is merely a reallocation process, he reasoned.

“We’re actually at the first stage of a bear market and it’s during that time that people start to look for other asset classes than stocks, like commodities or gold. It’s a little bit like rearranging the deck chairs on the Titanic.

“Once stock prices begin to really fall, people take money out of everything and put it in the bank.

“That’s when correlations are increasing between assets. Everything is in free fall at that point.”

Morgan Stanley & Co. LLC is the agent.

The notes are expected to settle on Wednesday.

The Cusip number is 61766YCS8.

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