July 7, 2008

JP Morgan Asia Confidence note

I was reading the papers, and this advertisment caught my eyes. It is called "JP Morgan Asia Confidence note". So I called up to check it out.

This structure is as follow :

1)Tenure of 2.5years

2)7.5%p.a coupon fixed – payable quarterly.

3)Based on Singapore, Malaysia, Thailand and Taiwan Indices movement.
Buffer level for Principal to be affected @ 50% - i.e. index must fall by 50% for
Principal to be affected.

4)Early callable every quarter.

On the face of it, this structured notes looks good, so I asked more questions on the product. This is what I understand from the marketing officer :

The product pay 7.5% p.a. coupon fixed on a quaterly basis, but is callable every quarter. What does this mean? This mean that if at every quarter, if the 4 indices are above the initial price, the bank has the right to "call" the product, i.e., the product will no longer exist as the bank will pay you the principal to redeem the product.

If throughout the 2.5 years, any one of the indicies fell 50% from the initial price, the trigger comes in. You do not know your loss at this point in time, because you need to wait till the end of the 2.5 years to see where does the worst index ends. If the worst index ends above the initial price, than no loss is incured. If the worst index ends below the initial price, the loss will be the difference between the initial price and the price at the end of 2.5 years.

It sounds complicated in words, so a decision tree illustration may be helpful :

Assuming that the initial price for all 4 indicies are 100, and the initial investment is $100,000. Than

Step 1: Did an early redemption event occur? i.e. ALL indices close above Initial Price

*If YES, Note is early redeemed, Noteholder receives 100% principal

*If NO, proceed to next step

Step 2: Did a Trigger Event occur?i.e. Is conditional principal protection still valid? Did any Index close below 50% of their respective Initial Price?

*Note: There is NO need to proceed to step 3 if Step 2 does not occur.

Step 3: At maturity (Final Valuation Date), did Straggler (least performing index) close above its Initial Priceof 100?

*If YES, Noteholder receives 100% principal, i.e. $100,000.

*If NO, Noteholder receives (Straggler Final Price / Straggler Initial Price) x Principal.

Assuming that the final price of the worst index is say at price 60, than you receive $60,000 plus whatever coupon you received before the expiry date.

Is this a good product? Well, it really depends on your view of the market. Let me explain.

Because of the nature of this product is structured, the investor have limited upside but unlimited downside in theory. If the 4 market (Singapore, Malaysia, Thailand, Taiwan) close above the inital price of say 100 (this is just a price I use for illustration) immediately in the first quarter, investor only received the 7.5% p.a., i.e., $1,875 for 1 payment, and the bank than redeem the note.

Therefore, the only way for the investor to receive the full number of cipon payment if for the 4 market indices to trade below the initial price for the next 2.5 years. However, you do not want the market to trade too low to have the triggered event kicks in, if that is the case, you have a possibility of losing your capital. Remember that the triggered event is if any of the 4 indicies close below 50% of the initial price. If this is to happen, what is the chance of it rebound above the inital price before the 2.5 years is up? Say the Thailand market fell 50% after 1 year, thus the triggered event kicks in, and you must than hope that the Thailand market can rebound 100% in the next 1.5 years so that you will not loss money, quite an unlikely event.

Furthemore, the way it is structured, it is a "diversification in reverse". If you put money into the 4 market, you hope to diversify, in case any one market tank badly, you will not be affected that badly. However, in this structure, any one market tank will drag your whole porfolio down since it is basked on any one market that fell 50%. Therefore, if say Thailand market is affected by its political situation and tanked 50%, even if other market make 100%, 200% or 300%, it does not matter, you will not make a single dime because of the Thailand market.

In my view, this product is good if you think that the market will at least go lower and remain low for awhile, but not too low to let the triggered event kicks in. market may consolidate for a while, but it is unlikely that it will remain within a range for 2.5 years.

So do not expect to get 7.5% p.a. for the full 2.5 years, chances are that if market recovers, this structured notes will get redeemed sooner rather than later.

As an aside, this product looks like the investor is selling a call optionon the 4 market at the initial price of 100, and at the same time, also sell a put of the 4 market at the initial price of 100, but with a knock-in at 50% below the intial price, i.e., at 50.

May 26, 2008

The (Whole) Truth about Trading Performance

I bump into my friend this morning while having breakfast. She is now working in a local bank as a private banker.

We had some small talk, and I mentioned to her that I am doing some trading on the side, and if things work out smoothly, than within the next 2-3 years, the income that I generate from my trading should be about the same or even exceed my pay. She is curious if I will just quit my job and do trading for full time.

I told her that it depends if I am happy at that time with my company and boss. If I am happy (or at least able to take the nonsense from my boss), than I just stay put. At the end of the day, I am like getting paid 2 salary (one from my normal job, and another from my trading). Moreover, I developed a trading methodoloy where by it does not depend on the direction of the market, which somebody call this market-neutral trading. The good thing is that it requires very little attention from my part, the bad thing is that I will not be able to generate super normal profit (hey, you need to give and take). But if I can make it, than at least I have a choice, and to me, such choice is very important in this day and age whereby you do not know when you will be axe...

From my friend's expression, she is as if asking me what sort of return I am making. I told her that I started trakking the performance from Jul 2007. I benchmark my performance against the exchange traded fund SPY (this is an exchange traded fun that track the performance of the S&P 500). Since Jul 2007, SPY return is -5.54%, while my trading performance is +11.67%, thereby outperforming the SPY by 17.21%.

My cumulative return on a month-to-month basis is as follow :

Date SPY S&P Return Fund Return
7/31/2007 145.72 (SPY) (in USD)
8/31/2007 147.19 1.01% -4.52%
9/30/2007 152.58 4.71% -3.04%
10/31/2007 154.65 6.13% -1.10%
11/30/2007 148.66 2.02% 0.64%
12/31/2007 147.10 0.95% 1.36%
1/31/2008 137.37 -5.73% 1.12%
2/29/2008 133.82 -8.17% 6.32%
3/31/2008 131.97 -9.44% 5.32%
4/30/2008 138.26 -5.12% 7.09%
5/23/2008 137.64 -5.54% 11.67%

My trading performance seems to be very good compared with a passive buy-and-hold strategy (compared with buying the index fund of SPY, whereby the return is -5.54%), however, I told my friend this is infact a little misleading. The reason is that before Jul 2007, I have been losing money. I gone through a period of trial and error, research etc. to find a trading method that is suitable for me, and only than I started to turn in some profit.

And this bring me to my topic today.

As one can see from above, my trading underperform from Aug to Nov, but outperform from Dec to May. If I want to mislead people, I will simply show people my trading performance from Dec onwards.

Many times, one read from the papers about courses that teach readers how to trade FX or options, and the advertisements are full of testimonials from students that make tons of money. Is that the truth? The Straits Times wrote an article 1-2 months back. One reader wrote in to the forum and said that his friends lost alot of money. So why the difference?

I think the answers are as follow :

1) the advertisement told the truth, but not the whole truth.

For example, in an advertisement of option trading, the student claim that he made 1000%. While I have no doubt that this is true, however, that trade may be the ONLY trade that he make money. That is to say, he can be making 20, 30, 50 trade, but only one trade happen to make 1000%, and overall he still lose money.

Another possibility is that the student just buy a very cheap option, like $0.10 per contract before the earnings result. It happen that on that particular quarter, the results beat expectation by a wide margin, and the stock price went up. The option than jumped from $0.10 to $1.00. The result is that the student make 1000%, but in absolute term, only make $0.90!

So what's the point, you may ask, for making 1000%, when in absolute term he only make $0.90 (or $90 per contract)?. This has to do with the "Option Competition" organised by the trainer. The trainer organised an option trading competition, and will give out awards to student that make the most in term of percentage gain. In order to "make it", students can make many small bets by buying very cheap option, like the $0.10 option. If the trade gone wrong, he loss $0.10 (or $10 per contract), but if things gone right, he can boast about the 1000% gain.

2) unrealistic expectation.

One must realised that trading is just like any other profession, to be good at it, you need constant learning and practise to improve your skill. A doctor taks 6 years of medical school to get to where he is, ditto for dentist, architect etc, so what makes one think that he can master trading just within a 3-4 day seminar?

3) the trainer himself is questionable.

Will you want to learn from Warren Buffett (the richest man who make his money fromm investing), or will you want to learn from a Mr. Tan Ai Kou who you have never heard before? The answer is obvious. However, there are many traders out there that can and had make their money, but is not as well known as Warren Buffett, so the only way to be sure is to ask them for their trading account. If he can produce his trading account and show that he can consistantly make money in the past, than you will be more comfortable learning from him. One should ask for the statement for at least 18 months to be certain, if not, the trainer can simply show you a very short period of time that he happen to make money (like if I only show others my "track record" from Dec to May).

4) Failed to understand own personality and style.

There are many trainers out there that are true trader that make their money. unfortunately, their methd f trading may not be suitable for you. Take an extreme example. Warren Buffet is well known for his buy and hold style. He identify solid companies and hold it for years and decade. Now, if one day, Warren Buffett knock on your door and offer to teach you everything he know, will you become Warren Buffett the second? if you are one of those that itch for action and are impatient, you cannot even hold the stock for 3 days, not to say 3 months or 3 years. Than you will end up making losses eveytime the market is against you and you just get out of your position. The stock may ultimately goes up, but you are not there to take advantage already. Warren Buffett's method work-- for him, but unfortuantely, it does not work for you.

February 26, 2008

Capital Protected Note in EUR

Last month, my boss gave me a note. The note outlined a structured product call Capital Protected Note (CPN). My boss was very excited over the product and asked me what I think.

The CPN works like this :

"The CPN enables you to participate in the positive development of an equally weighted currency basket composed of a selection of 5 emerging currencies (BRL, RUB, IDR, INR, ARS) against USD while remaining invested in EUR."

If the basket of currency falls, you get 101.50% of your capital upon maturity. If it appreciates, you get 117%.

Once I saw such structure, I immediately know that the bank is trying to rip the customers off. The bank do it by several ways, but before I get to that, I need to break down the components of the structure.

1) The bank take your EUR which has a higher interest rates compared to the USD. They than hedge it buy doing a currency swap, whereby the interest rate differential is in their favor. In this way, no risk of the EUR/USD exchange rate is hedged and therefore there is no risk for the bank. They than tell the customer that the customer can invest in EUR without any EUR/USD risk, which in actual fact, the customer lost out!. The estimated lost to the customer is about 0.50% on this component.

2) The bank than go and buy what we call a "basket option" of the 5 currencies. Specifically, the bank buys a USD put against the 5 currencies. A basket option is cheaper than if the bank were to buy USD put against each individual currency because as a basket, there is diversification and offsetting of the volatility. The is the second component that the bank rip customer of without telling them.

3) Because the USD interest rate is very low and the basket currencies are of high interest rate currencies, the USD put is very cheap. So what the bank does is to take the customers' money, use a small portion to buy option, and than invest the balance into instrument like FD or T-Bills. The yield from FD and T-Bills will be more than enough to cover the cost of the option and thus making the structure "capital protected". The bank than charge a "management fee" of 1%.

The customer, like my boss, were trailed by such products because they do not understand how it was structures and how it can be done cheaply by themselves.

However, I feel very sad after I showed my boss how we can structured the same product at a lower cost and also avoiding paying the bank 1% management fee. My boss, who is initially very excited with the product, lost interest just because I show him I can structured it. He must be thinking if I can structured it, than the product must be not very complex and thus do not want to invest in such simple product.