Nicole Wachs provides some easy to use information.
This blog was prompted by some comments from Dan Sheridan's post, Top Five Reasons to Trade FROs. Thanks for the questions Locogmac. Below I will illustrate with examples how to calculate the max gain, max loss, and margin / capital requirements when trading any single leg FRO trade. Trading permissions are included as well. If you are new to FROs, please access Brian Overby's whitepaper here. To round out this blog, at the bottom I will provide links to several other posts on the subject. If you have some FRO links to add, please do!
THE LONG PLAYS:
LONG FINISH HIGH LONG FINISH LOW
Click here for a larger image of Long FRO Plays.
THE SHORT PLAYS:
SHORT FINISH HIGH SHORT FINISH LOW
Click here for a larger image of Short FRO Plays.
ALL-STAR COMMENTARY
I have provided four examples (images are above, data is below) with the aim of removing any confusion with margin requirements and trading permission levels. What you should notice is that there's a simple trick to figuring out the margin / capital requirements, max gain, and max loss: the numbers are always a function of $1.00. See my figures to understand this better.
Another thing to keep in mind is that the VWAP is used to determine settlement, not the underlying stock price. In most cases, these amounts will differ. For an example, please click here. Often times the VWAP symbol is the same as the FRO symbol. To learn more about the use of the VWAP, please click here.
LONG EXAMPLES
If you buy or go long a Finish High (FH) FRO or a Finish Low (FL) FRO, you must pay the premium in full. The trade will result in a debit to your account and your maximum risk is equal to this debit. This is very similar to going long a call or long a put.
Long 1 Jan 40 XYZ FH FRO for $0.33 per contract per share
Capital requirement = $0.33
Max gain = $0.67 ($1.00 - max loss)
Max gain reached at expiration when XYZ VWAP > 40.00
Max loss = $0.33 debit paid
Max loss reached at expiration when XYZ VWAP < or = 40.00
Break-even at expiration: none (see image above)
Option level required: Level 2
Bullish trade
Long 1 Jan 40 XYZ FL FRO for $0.70 per contract per share
Capital requirement = $0.70
Max gain = $0.30 ($1.00 - max loss)
Max gain reached at expiration when XYZ VWAP < 40.00
Max loss = $0.70 debit paid
Max loss reached at expiration when XYZ VWAP > or = 40.00
Break-even at expiration: none (see image above)
Option level required: Level 2
Bearish trade
SHORT EXAMPLES
If you sell or go short a Finish High (FH) FRO or a Finish Low (FL) FRO, you will create a credit in your account. This credit must remain in your account and cannot be used or withdrawn provided the position is still open. Furthermore, you must have additional funds in your account to meet the margin / capital requirement of $1.00 per contract per share. The credit from each trade is applied to the $1.00 requirement.
Short 1 Jan 40 XYZ FH FRO at $0.33 per contract per share
Capital requirement = $1.00
Max gain = $0.33 credit received
Max gain reached at expiration when XYZ VWAP < or = 40.00
Max loss = $0.67 ($1.00 - max gain)
Max loss reached at expiration when XYZ VWAP > 40.00
Break-even at expiration: none (see image above)
Option level required: Level 2
Bearish trade
Short 1 Jan 40 XYZ FL FRO = $0.70
Capital requirement = $1.00
Max gain = $0.70 credit received
Max gain reached at expiration when XYZ VWAP > or = 40.00
Max loss = $0.67 ($1.00 - max gain)
Max loss reached at expiration when XYZ VWAP < 40.00
Break-even at expiration: none (see image above)
Option level required: Level 2
Bullish trade
Here are those links I promised:
Top Five Reasons to Trade FROs by Dan Sheridan
MSFT Finish Low FROs and High on Profit by Larry McMillan
FROs: Some Key Differences by Nicole Wachs
FROs: Getting in the Know by Doc Maher
Betspreads: FROs and Multi Leg Trades by Nicole Wachs
FROs: Red or Black by Larry McMillan
FROs: Top Ten Links by Nicole Wachs
If you have more questions, please post below.
Thanks!
"Insight Specialist"
TradeKing Staff
Nicole's previous posts: Using Delta to Trade Strangles and Near Worthless Options Can Inflict Much Pain
For a list of previous All-Star Trades, please click here.
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Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
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.
