Falling Apple's Price Causes Reverse Convertible Damage

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Falling Apple's Price Causes Reverse Convertible Damage

Postby stratton » Fri Jan 25, 2013 8:45 pm

Falling Apple's Price Causes Collateral Damage

Lots of Apple reverse convertibles out there.
Under these notes, often called "reverse convertibles", it appears to an investor that he or she is buying a fixed income or bond-like investment which would rise as the price of Apple rises and that the return would mimic or exceed the return of the Apple stock while acting like a bond. Unfortunately, as Apple has cratered in value, so has the value of the Apple based structured notes.
...
"More than $241 million of structured notes tied to Apple Inc. face losses after a 27 percent drop in the stock of the world's most valuable company eroded built-in cushions that protect investors," Dugan wrote. "Banks issued 76 US notes linked to Apple stock during the seven weeks starting August 20 when the company was valued at $650 a share or more," Dugan continued. In total, banks issued $1.66 billion of such notes, making Apple the most popular underlying company in such high commission structured products.

Here's a couple of examples yielding 9% and 12%. Both convert to AAPL stock if they drop 20%.

Reverse Convertible Notes 3720 - Apple
This is an income product linked to the share of Apple.The product offers a coupon of 9% p.a., paid monthly throughout the investment period.At maturity, the product offers a capital return of 100%, if the final share level is equal to or greater than the initial level or if the underlying does not fall by more than 20% from its initial level at any time during the investment. If the underlying do...


Reverse Convertible Non-Principal Protected Notes - Apple
Reverse Convertible Non-Principal Protected Notes - Apple

This is an income product linked to the shares of Apple.The product offers a coupon of 12% p.a., paid monthly throughout the investment period.At maturity, the product offers a capital return of 100%, if the final share level is equal to or greater than the initial or if the underlying does not fall 20% or more during the investment. If the underlying does fall 20% or more during the investment an...

From May 31, 2011 FINRA Takes Aim At Brokers Selling Reverse Convertible Notes

ALPS was going to do a Reverse Convertible ETF at one point, but I don't think it made it past the SEC.

http://www.indexuniverse.com/sections/n ... e-etf.html

Stating the obvious: Beware of structure products and yield hogs can get slaughtered.

Paul
...and then Buffy staked Edward. The end.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby baw703916 » Fri Jan 25, 2013 9:23 pm

All the risk of stocks, but a lot less tax efficient.

What's not to like? :happy
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby Calm Man » Fri Jan 25, 2013 10:15 pm

How do they find people stupid enough to buy something like this?
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby VictoriaF » Fri Jan 25, 2013 10:28 pm

Calm Man wrote:How do they find people stupid enough to buy something like this?

Financial advisers are known to propose innovative investment options.

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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby damjam » Fri Jan 25, 2013 10:32 pm

So let me see if I've got this.
If the price of the stock the Reverse Convertible is linked to stays even, increases, or declines by no more than 20%...the investor gets their 9% or 12% interest payments for a specified period and return of their invested capital at the end. If the stock price declines by more than 20% at any time during the specified period the Reverse Convertible converts to shares of the linked stock and there are no more interest payments or return of capital.
If I have this straight, I can't think of a single reason why this would be a good idea.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby tfb » Sat Jan 26, 2013 2:45 am

Not bad to acquire some AAPL at low price.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby Fallible » Sat Jan 26, 2013 9:19 am

damjam wrote:So let me see if I've got this.
If the price of the stock the Reverse Convertible is linked to stays even, increases, or declines by no more than 20%...the investor gets their 9% or 12% interest payments for a specified period and return of their invested capital at the end. If the stock price declines by more than 20% at any time during the specified period the Reverse Convertible converts to shares of the linked stock and there are no more interest payments or return of capital.
If I have this straight, I can't think of a single reason why this would be a good idea.


What?! You don't believe the brokers who said the notes were "safe and guaranteed"?!! You don't believe the notes are a way to benefit from an Apple rise "without the risk"?! :shock:

You must be a Boglehead. :)
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby midareff » Sat Jan 26, 2013 10:11 am

Calm Man wrote:How do they find people stupid enough to buy something like this?


the "mark" can be identified by their eyes glazing over at hearing 9% or 12% and the rest of the sale is easy.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby Drain » Sat Jan 26, 2013 10:47 am

damjam wrote:So let me see if I've got this.
If the price of the stock the Reverse Convertible is linked to stays even, increases, or declines by no more than 20%...the investor gets their 9% or 12% interest payments for a specified period and return of their invested capital at the end. If the stock price declines by more than 20% at any time during the specified period the Reverse Convertible converts to shares of the linked stock and there are no more interest payments or return of capital.
If I have this straight, I can't think of a single reason why this would be a good idea.

Seriously? Think a little harder. Assuming you have this right (I'm not reading the article), it sounds like an interesting investment to me. Within the 20% band, you receive a high rate of interest. You lack the upside of the stock, but you also miss the downside. If the stock drops 20%, you pick up shares at--if you've done some good analysis--a bargain price.

Think about that. Let's say you think the stock is a bargain at 20% below its current price. You buy these reverse convertibles, and you get the stock at a price you like. Meanwhile, you skip the 20% loss and you pick up a little interest. That doesn't necessarily sound stupid to me. But I'm just going by your description, and maybe the reality is worse.

In general, I don't believe there is an investment (excluding insurance products) that doesn't make good sense in some situations. I don't believe you can legitimately dismiss a type of investment out of hand without knowing its ins and outs and without knowing an investor's specific circumstances.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby Don Christy » Sat Jan 26, 2013 8:01 pm

Drain wrote:
damjam wrote:So let me see if I've got this.
If the price of the stock the Reverse Convertible is linked to stays even, increases, or declines by no more than 20%...the investor gets their 9% or 12% interest payments for a specified period and return of their invested capital at the end. If the stock price declines by more than 20% at any time during the specified period the Reverse Convertible converts to shares of the linked stock and there are no more interest payments or return of capital.
If I have this straight, I can't think of a single reason why this would be a good idea.

Seriously? Think a little harder. Assuming you have this right (I'm not reading the article), it sounds like an interesting investment to me. Within the 20% band, you receive a high rate of interest. You lack the upside of the stock, but you also miss the downside. If the stock drops 20%, you pick up shares at--if you've done some good analysis--a bargain price.

Think about that. Let's say you think the stock is a bargain at 20% below its current price. You buy these reverse convertibles, and you get the stock at a price you like. Meanwhile, you skip the 20% loss and you pick up a little interest. That doesn't necessarily sound stupid to me. But I'm just going by your description, and maybe the reality is worse.

In general, I don't believe there is an investment (excluding insurance products) that doesn't make good sense in some situations. I don't believe you can legitimately dismiss a type of investment out of hand without knowing its ins and outs and without knowing an investor's specific circumstances.


Emphasis mine.

For fun, I read the prospectus on one of these. Seems the opposite of your assumption is true. You get none of the upside and ALL of the downside. If the price drops below the threshold, you get shares worth the current price INSTEAD of your principal back.

So example: you buy $10,000 worth of these things.

Scenario 1: price drops or rises a 5%. You get your principal back plus the interest. Not bad.

Scenario 2: price rises 30%. You get your principal back plus interest. Still not bad relative to real fixed income, but you don't participate in the equity upside.

Scenario 3: price drops 30%. You get no interest and get $7,000 cash (or shares at that value, their option). Terrible. You didn't buy cheap, you paid $10,000 and got $7,000 in shares.

I can't imagine how this investment would be good for anyone other than the person collecting the commission.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby phantom » Sat Jan 26, 2013 8:27 pm

Don Christy wrote:So example: you buy $10,000 worth of these things.

Scenario 1: price drops or rises a 5%. You get your principal back plus the interest. Not bad.

Scenario 2: price rises 30%. You get your principal back plus interest. Still not bad relative to real fixed income, but you don't participate in the equity upside.

Scenario 3: price drops 30%. You get no interest and get $7,000 cash (or shares at that value, their option). Terrible. You didn't buy cheap, you paid $10,000 and got $7,000 in shares.

I can't imagine how this investment would be good for anyone other than the person collecting the commission.


I guess this is one of those things you buy if you want to bet on the price of the stock staying approximately the same. If you believe the stock will rise - you buy the stock, if you think it will fall - you short it, and if you think it'll stay the

same - you buy this thing. How else can you profit from a non-moving market? (I am not arguing that this is a good *investment*, just that it has a purpose).
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby happymob » Sun Jan 27, 2013 1:05 am

baw703916 wrote:All the risk of stocks, but a lot less tax efficient.

What's not to like? :happy

All the risk of a single stock, rather than "stocks" (in the index sense). Which makes it doubly ridiculous. But please, sign me up for any products tied to Apple. Or Exxon. Or General Electric. Or Enron. Or Polaroid. They all seem solid.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby Don Christy » Sun Jan 27, 2013 9:26 am

phantom wrote:
I guess this is one of those things you buy if you want to bet on the price of the stock staying approximately the same. If you believe the stock will rise - you buy the stock, if you think it will fall - you short it, and if you think it'll stay the

same - you buy this thing. How else can you profit from a non-moving market? (I am not arguing that this is a good *investment*, just that it has a purpose).


Problem is, it's sold as an income product. It's a very risky income product. Seems the risk isn't well compensated.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby Drain » Sun Jan 27, 2013 4:50 pm

I bounded this off a friend, who skimmed the article and read the SEC description. He says that buying this "reverse convertible" is essentially selling a naked put, and that's about it. So yes, it's risky, but also yes, there are legitimate reasons someone might want to do it.

Renaming the writing of a naked put as a reverse convertible doesn't make JP Morgan look particularly good, but what else is new? "Selling a naked put" sounds appropriately scary and (almost) only investors who knew what they were doing would have bought it. If, instead, JPM sold it as almost a bond...well, that would be pretty unethical.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby tfb » Sun Jan 27, 2013 7:52 pm

Drain wrote:I bounded this off a friend, who skimmed the article and read the SEC description. He says that buying this "reverse convertible" is essentially selling a naked put, and that's about it. So yes, it's risky, but also yes, there are legitimate reasons someone might want to do it.

Sounds like selling a covered put, not a naked put. Money is there upfront to cover the put. A covered put is one of the least risky in options.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby Van » Sun Jan 27, 2013 8:16 pm

As I learned from Jane Bryan Quinn (Newsweek) many years ago, "Never invest in something you do not completely understand."
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby talzara » Sun Jan 27, 2013 11:28 pm

tfb wrote:
Drain wrote:I bounded this off a friend, who skimmed the article and read the SEC description. He says that buying this "reverse convertible" is essentially selling a naked put, and that's about it. So yes, it's risky, but also yes, there are legitimate reasons someone might want to do it.

Sounds like selling a covered put, not a naked put. Money is there upfront to cover the put. A covered put is one of the least risky in options.


What you're describing is a cash-secured naked put. It's cash-secured, so there's no leverage involved. But it's still naked.

A covered put is when you write a put, and short the stock by an offsetting amount. It is the exact opposite of a covered call - in which you write a call, and then buy an offsetting amount of the stock.

--

Drain's friend is almost correct. This product is actually composed of two puts -- a vanilla European put option, paired with a European binary put option. The binary option is responsible for generating the payoff discontinuity at the trigger price.

For example, the structured products described in the original post have a trigger price 20% below the initial price. If AAPL falls 1% -- or even 19.99% -- then the investor does not lose any principal. If AAPL falls 20% or more, then the investor gets the full loss -- starting at 20%, not 0%. It's the binary option that makes this possible.

The news articles all seem to be based primarily upon this analysis by Securities Litigation and Consulting Group, released two days ago: http://slcg.com/pdf/workingpapers/The%2 ... oducts.pdf No doubt they're hoping to get hired for a lawsuit against the big banks.

The same company did a very interesting analysis of a particular offering of AAPL-linked USB Trigger Yield Optimization Notes, which were sold right at the peak of AAPL's share price: http://slcg.com/pdf/tearsheets/90270B489.pdf

  • Pricing date: September 21, 2012
  • Valuation date: September 23, 2012.
  • Terms: 12 months, 8.03% coupon, paid monthly.
  • Trigger level: 85% of AAPL's initial share price.
  • Issue price: $700.71
  • Fair price at isue: $671.59

In other words, UBS pocketed $700.71 - $671.59 = $29.12. That's a 4% fee for a 1-year note. Not too shabby!

Actually, it gets even better than that. The bond component is just there to fool people into thinking that this is a fixed-income security. The options premiums are disguised by being paid out monthly, as "bond coupons." According to SLCG's calculations, if you strip out the bond component, then the two options are worth $74. In other words, UBS is charging a 39% fee on the options. Thirty-nine percent!!!!!!!

This is why the investment banks love structured products. They're a license to legally steal the client's money.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby tfb » Mon Jan 28, 2013 2:47 am

talzara wrote:What you're describing is a cash-secured naked put.

You are right. Cash secured put. Although naked sounds bad, isn't it actually less risky than a covered put? A covered put can lose more than 100%.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby bberris » Mon Jan 28, 2013 9:59 am

Drain wrote:I bounded this off a friend, who skimmed the article and read the SEC description. He says that buying this "reverse convertible" is essentially selling a naked put, and that's about it. So yes, it's risky, but also yes, there are legitimate reasons someone might want to do it.

Renaming the writing of a naked put as a reverse convertible doesn't make JP Morgan look particularly good, but what else is new? "Selling a naked put" sounds appropriately scary and (almost) only investors who knew what they were doing would have bought it. If, instead, JPM sold it as almost a bond...well, that would be pretty unethical.


There's two issues here. You've already discussed the hidden nature of the investment. Most of the people buying this crap would think that a naked put is soft-core pornography. The other part is cost. If a sophisticated investor wanted this sort of thing, he would just sell the put. That's what the investment bank did. The extra cost of this packaging has been estimated at 6-10 % and sometimes higher.
Last edited by bberris on Mon Jan 28, 2013 5:13 pm, edited 1 time in total.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby talzara » Mon Jan 28, 2013 1:15 pm

tfb wrote:You are right. Cash secured put. Although naked sounds bad, isn't it actually less risky than a covered put? A covered put can lose more than 100%.


Yes, that's right.

In terms of payoff, a naked put is equivalent to a covered call -- you can only lose 100% of the strike price. Whereas a covered put is as risky as a naked call -- you can lose an unlimited amount.

Naked puts have historically been considered to be riskier than covered calls, because of margin. Regulation T requires greater initial margin to be put up for a covered call than for a naked put. A lot of people got into trouble in the 1980s by overleveraging on naked puts, and that's where the reputation comes from.

These days, it doesn't matter quite so much, because Regulation T has fallen by the wayside. Portfolio Margin considers naked puts to be equivalent to covered calls. Same payoff, same risk = same margin.
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Re: Falling Apple's Price Causes Reverse Convertible Damage

Postby af895 » Mon Jan 28, 2013 1:20 pm

After reading most of the posts in this thread, I was reminded of an article I read recently:

Staying Out of the Murder Holes
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