Dan Sheridan shares his take on this new investment product.
You're bearish on a certain stock, but not overly so. Shorting stock is one method to use here, but you would rather not tie up so much capital in one position. A long put is an alternative, but the negative effects of time decay concern you. A short call would remedy that draw back, but the idea of unlimited risk is both unsettling and capital intensive. Is there anything left? Definitely - Fixed Return Options or FROs for short. This type of option was created to simplify your concerns and in the following post I explain why I like them. If FROs are new to you, check out FROs - Top Ten Links by Nicole Wachs or Brian Overby's whitepaper to jump right to the details.
THE PLAY - Short Finish High Fixed Return Option
TRADE FORMATION
On August 12th at 12:07pm, Community member V!NCE entered the following:
Strike A: Sold to open 3 GS August 175 Finish High FROs (TLG HO) at 0.23
Stock at entry: GS near 171
VWAP* at entry: GS near 172
Short Finish High FRO entry: 0.23 credit
Maximum gain: 0.23 credit; achieved if TLG < or = 175
Maximum loss: 0.77 (1.00 - credit); achieved if TLG > 175
Break-even point at expiration: None; FRO trades do not have break-even points
On August 15th at expiration:
Strike A: 3 Short GS August 175 Finish High FROs (TLG HO) expired worthless
Stock at close: GS 163.18
VWAP* at close: GS 164.62
Maximum profit was achieved if position was held through expiration
Short Finish High result: gain of 0.23
ROI: 0.23 / 0.77 = 29% in 3 days** (excluding transaction costs)
*VWAP: The Volume Weighted Average Price (also known as the AMEX FRO Settlement Index) determines the result of a FRO trade at expiration instead of the underlying stock price. In most cases, the expiration closing prices of these values will differ. Please see the two charts below for an illustration of this point. In addition, the VWAP is not a cumulative number carried over the course of days, weeks, or months. Because it resets each day, the stock price is typically used to formulate trading ideas if entering a position before expiration day. To learn more about the use of the VWAP, please click here.
**NOTE: This return represents past performance and does not guarantee future results.
Click here for a larger GS stock chart.
Click here for a larger GS TLG VWAP chart.
ALL-STAR COMMENTARY
Here's why I like Fixed Return Options:
1. FROs are a great way to sell naked options without the horrible consequences!
Take Community trader V!NCE. He was able to sell a Finish High option for .23 and limit his risk to a MAXIMUM amount of .77. Can you tell that I'm excited? It's like selling options with training wheels. I love it! Much less chance of going broke than when selling conventional options!
2. FROs are a great tool for beginners with little experience!
This investment vehicle allows beginning option traders to look like seasoned risk managers. V!NCE's trade works out to a 3:1 Risk-Reward-Ratio. What if V!NCE sold a naked call option for .23? Could it balloon to $9.00? Of course! Ouch! What if V!NCE sold a 10-point credit spread for .60, what is the maximum risk on this trade? $9.40! Jeez Louise! This is a wonderful way for beginners to ease into selling options without the risk of catastrophe (as long as they keep the number of contract small).
3. FROs are a good alternative to Credit spreads!
V!NCE sold the August 175 Finish Highs in Goldman Sachs for .23 with stock near 170. Only one option was traded versus two to enter a credit spread. And the Risk-Reward-Ratio will most likely be better with the FRO versus a call credit spread.
4. No need for advanced orders!
Although necessary for the responsible risk management of standard call and put positions, learning how to put in stop and contingent orders can be tricky. With FROs, you don't need to worry about the underlying causing a big loss if it moves against you at lightening speed. You don't have to worry about getting fleeced getting out of a bad trade. (As long as you keep your position size small relative to your account size.)
5. FROs are great for call buyers too!
Because there is a fixed return of $100, the buyer can't get killed anywhere as bad as with regular options. What if you bought GOOG options at $12.00, how much can you lose? The answer is $12.00! Which is much, much, much more than a FRO purchase of less than a buck.
Regardless of his experience, V!NCE comes off looking like a pro with this successful trade. What's more is his streak continues! In summary, this product is what AAA baseball is to the major leagues. Fixed Return Options allow many novice option traders to stay in the game long enough to really learn it. Inevitably, FROs may protect option sellers and buyers from themselves. By nature FROs remove the potential of the horrible huge losses that time and again prematurely end careers. I will strongly encourage my new students to trade FROs before they graduate onto credit spreads, calendars, and butterflies. This product lets traders develop skills before taking on all the responsibilities of a major league option trader!
Owner and Mentor
Dan's previous posts: Deciding When to Use Leap Calls and Strangle Guidelines for Momentum Stocks
For a list of previous All-Star Trades, please click here.
Would you like your Trade Note to be chosen? Read more.
This comment and any market data included here were prepared on 8/22/08.
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 on these trades represent past performance and does not guarantee future results.
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.
Dan Sheridan has a professional business relationship with TradeKing.
