Lawrence McMillan discusses Aaron's great return.
Your bullish on a certain stock, but you don't have an upside target. You also do not want to experience the negative effects of time decay. A short put play would work here, but you also want limited risk. If you are in luck, your underlying may have Fixed Return Options available. The equivalent strategy would be to short a Finish Low. If Fixed Return Options or FROs are new to you, check out Nicole Wachs' blog: FROs - Top Ten Links.
THE PLAY - Short Finish Low Fixed Return Option
TRADE FORMATION
6/3/08 - 1:52 pm
On June 2nd at 1:35 pm, Community member Aaron20A2000 entered the following:
Strike A: Sold to Open 1 MSFT June 28 Finish Low FRO at 0.56
Stock at entry: MSFT near 28
VWAP at entry: RIS near 28
Short Finish Low entry: 0.56 credit
Maximum gain: 0.56 credit; achieved if RIS > or = 28.00
Maximum loss: 1.00 - credit = 0.44; achieved if RIS < 28.00
Break-even point at expiration: None; FRO trades either make money or they don't
On June 20th RIS closed at 28.47
Maximum profit was achieved if option was held and expired worthless
Short Finish Low result: gain of 0.56
0.56 / 0.44 = 127% ROI in 19 days* (excluding transaction costs)
*NOTE: This return represents past performance and does not guarantee future results.
Trading activity is no longer available for this trader. Profit and loss were determined by expiration data only.
The idea here is for the stock to stay above Strike A. In actuality, the VWAP will determine the result of this trade, but remember this value is reset each day. Because the VWAP is not a cumulative number carried over the course of days, weeks, or months, the underlying is typically used to formulate trading ideas if entering a position well before expiration. For more Fixed Return Option information, please check out Brian Overby's white paper.
ALL-STAR COMMENTARY - by Lawrence McMillan
At face value, this trade is a simple bet that Microsoft finishes above 28 at June expiration. That is, the trader sold the "finish low" FRO (Fixed Return Option). An FRO can range in price only between 0 and 1.00. At expiration, a "finish high" FRO is worth 1.00 if the underlying is above the strike, or worth 0.00 if it's at or below the strike. Conversely, the "finish low" FRO is worth 1.00 if the underlying is below the strike at expiration, or worth zero if it isn't. MSFT closed at 27.75 that day.
These options can be valued with a simple probability calculator - one that calculates the probability of the stock being above or below the strike at expiration. Figure 1 shows the data from our calculator software, available from McMillan Analysis Corp. The red numbers in circles are not part of the actual software package, but I have added them so that it is easy to see the user inputs.
User input:
- 1) stock price. (27.75)
- 2) upside target price - meaningless in this case (set to 99999)
- 3) downside target price - the strike (28)
- 4) time until expiration (29 trading days)
- 5) volatility estimate. This is the most difficult input for any probability calculator or expected return analysis, for it influences the results tremendously. MSFT historic volatility has been pretty steady in the 30% neighborhood, so that's what we're using as the volatility estimate.
The numbers at the bottom of the screen are various results and probabilities. The one we're interested, in the case of this FRO, is the "Probability of closing below the lower target price." That is marked as number 6, circled, and is about 55%.
This trader sold his "put" for 0.56 (which translates as 56%), so he got fair value for the sale. That is a good execution in this thin, illiquid market.
Click here for a larger image.
The trader may feel that he got a terrific deal by selling essentially an at-the-money put for 56% chance of expiring worthless. But that's just fair value, due to the way that lognormal distribution affects stock movements, probabilities, and hence the value of these options. If you believe that stocks move in a distribution that is not lognormal (and there are plenty of people who would agree with you), then selling these FRO puts or buying the FRO calls might be a profitable endeavor.
President
For a list of previous All-Star Trades, please click here.
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This comment and any market data included here were prepared on 6/8/08.
Nicole Wachs contributed to this blog.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
The return of this trade represents past performance and does not guarantee future results.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Lawrence G. McMillan has a professional business relationship with TradeKing.
