A few nice features for Newbies.

Hi Runningpair,

Thanks for your comments on my previous blog on FRO spreads.  Although there are some similarities between FROs and other standard call or put strategies, there are many many differences. As such, I would say I disagree with your initial remark that they are unnecessary. A good analogy to make is the invention of the ETF. Both mutual funds and ETFs provide vehicles to purchase a diversified investment in one transaction, but they are still very different products, each with its own pros and cons.

Here are some key differences on the product specifications:

1. FROs are cash settled. Only cash will change hands after an exercise or assignment.

Standard equity options are settled in shares of the underlying.

2. FROs are European style exercise. That means there is no risk of early assignment.

Standard equity options are American style, which may be exercised at any time.

3. FRO settlement is based on the Amex FRO Settlement value (VWAP).

Standard equity options are settled based on the closing price of the underlying stock.

There are other differences too, but I would label the next one as conceptual in nature. The fact that a FRO's profit or loss is based on a predetermined amount of $100 per contract makes it easier for novices to understand.  Unlimited risk with standard options is not an easy thing to get one's head around when first starting out. Another advantage to the newbie is that when you trade a FRO, you spend only one commission. If you were to imitate a FRO risk profile with standard call or put vertical spread, one would incur twice as many commissions. And that is under the assumption that $1 strikes are available for the standard variety. In most cases, the strikes are $5 or $10 wide.

As for your second point, yes I expect there to be arbitrage opportunities for institutional investors. Right now, the quotes could be more competitive. As professionals get more comfortable with this new product, and get May expiration under their belts, I anticipate that quotes will be more competitive in the near future. Also more traders are slated to participate in these products, which will also tighten things up a bit. That being said, it would be a slim to none chance for a retail trader (average investor) to be able to take advantage of an opportunity, but things do happen.

Thanks again for the comments. It's always informative to hear what our customers are thinking!

Regards,

Nicole Wachs

TradeKing Staff

Click here to get started with FROs.

Click here for a list of my past blogs.

Options involve risk and are not suitable for all investors.

Please read Characteristics and Risks of Standardized Options.

Hi, Nicole,

I, too, thought there was only one commission going INTO the FRO. Then, today, I discovered that I got dinged $9.95 for "exercise" of my FRO that was in the money. What gives? I thought there were no settlement fees. You only paid one commission, as you stated above. Please elaborate.

Arbitrage example:  Stock @ 31.12  option 30 @ $1.  Buy the option and exercise it.  then sell stock @31.12.  You will have made $.12 with out taking any risk.  Arbitrage means making a certain profit with no risk.

Hi UpAndAway,

I know you already got the answer to your question, but I will repost it here for everyone's benefit.

In my blog, I state that buying or selling a FRO is more like buying or selling a spread due to certain characteristics. When trading a call spread or a put spread, one would have a commission for each leg.  For a FRO, it would have the characteristics of a spread, but only one commission to enter the trade. So when I said only one commission, I meant as opposed to two when trading a spread.

With any kind of options, there will be a commission to enter the trade and then one to close it. The only time there isn't a second commission is if the option expires worthless. If your option expires in the money, that is not worthless, and is subject to assignment charges (if short) or exercise charges (if long). Assignments (4.95) and exercises (9.95) are per occurrence and happen once per day.

I hope this helps. Sorry for the misunderstanding.

Thanks,

Nicole Wachs

Options involve risk and are not suitable for all investors.

Please read Characteristics and Risks of Standardized Options.