Jim,

Thanks for your questions. You bring up some good points that traders need to be mindful of when trading FROs. Before we move on to your questions, I would like to introduce a new term. Fixed Return Options are also referred to as bets. If you trade a FRO spread, that may be referred to as a betspread. To limit confusion, I will refer to trades with more than one FRO leg as a betspread. A trade in either a Finish High or Finish Low will simply be referred to as a FRO trade.

When you trade a single FRO, both the risk and the reward are limited. Because of this, FROs are similar to vertical spreads with strikes that are $1 wide. Here are some relationships:

Fixed Return Option Position           Near equivalent using standard listed calls & puts

Long 1 XYZ 110 Finish High            Long 1 XYZ Jan 110 call and Short 1 XYZ Jan 111 call

Debit trade                                     Long call debit spread

Short 1 XYZ 110 Finish High           Short 1 XYZ Jan 110 call and Long 1 XYZ Jan 111 call

Credit trade                                   Short call credit spread

Long 1 XYZ 110 Finish Low            Long 1 XYZ Jan 110 put and Short 1 XYZ Jan 109 put

Debit trade                                    Long put debit spread

Short 1 XYZ 110 Finish Low           Short 1 XYZ Jan 110 put and Long 1 XYZ Jan 109 put

Credit trade                                   Short put credit spread

So if you are interested in selling credit spreads with regular options, you may be interested in shorting Finish Highs or Finish Lows. The margin requirement in either case is $100 per contract sold, less the premium amount received.

For example, a Finish High FRO has a price of $0.30 per contract. If you would like to sell to open six contracts, you will need $600 (plus commissions) in the account in order to do the trade. However, the sale of the options generated $180.

Here's the math:

Sell to open 6 contracts with 100 multiplier = 6 x 100 multiplier = $600

Premium deposited from the trade at $0.30 per contract = $0.30 x 6 x 100 multiplier = $180

Requirement for customer = $600 - $180 = $420 plus commissions

If you were to trade a betspread, that would be more like trading a standard call or put butterfly or condor. A profit range would be defined, and most likely the outcome desired would be between the strikes used. The margin requirement in this case would only apply to the short leg of the betspread, applying the same math as described above for a single FRO trade. The strike prices used do not factor in to the margin requirement when trading betspreads.

As for your last note on expiration behavior, there is much discussion among professionals I know as to what will exactly happen as expiration Friday nears. If the VWAP and the short strike are near equal, I expect the option to retain half of its maximum value, even at the close. This is because on the last day of the option's life, it will be compared to the Amex FRO Settlement Index, which will not be disseminated until around 6pm ET. If the short strike and the VWAP are much further apart, I would expect the value to either approach one or to approach zero, reflecting whether it was in- or out-of the money respectively.

Thanks again! We appreciate the questions.

Regards,

--Nicole Wachs

TradeKing Staff

For a list of my previous blogs, click here.

Options involve risk and are not suitable for all investors.

Please read Characteristics and Risks of Standardized Options.

It seems to me that FROs are an unnecessart product.  As you point out they are already in the market place.  this raises the question do u expect arbitrage opportunities to exist.  And will the bid ask spreads abilerate any potenial to profit from market inefficentcy.

This reminds me somewhat of a sports bet on the over under.  However one which offers odds for a score total which differs from the one that has the maximum likelyhood of occurance. 

Just some musings.

Hi Runningpair,

I responded to your comments in a new blog post. Click here to read more.

Thanks,

Nicole Wachs

TradeKing Staff