Nicole Wachs addresses some concerns.
"I love the idea of trading FROs being like "options with training wheels" for people who don't want to deal with the potential of unlimited downside risk of standard options. However, the one thing that keeps me from trying them is the lack of liquidity in the marketplace. For example, I just checked MSFT, one of the few individual stocks available for FROS, and the bid/ask spread is ridiculous for Sept 08. There is no volume or open interest for any of the strike prices so it appears that everyone else is staying away too. I realize that FROs are new and many people aren't aware of them but I think that there are probably a lot of people like me or are not willing to take the loss on the wide bid/ask spreads. Any comments?"
-- Comment from S90911
S90911,
Thanks for a great question. As you have noticed, the bid and ask spreads on some Fixed Return Options (FROs) are wider than for standard listed options. New investment products can be a little tricky to trade when they first come out, and Fixed Return Options are no exception. For those that were involved when ETFs (Exchange Traded Funds) started trading, you may recall that the bid-ask spreads were over $1.00 wide! Ouch! But they have come a long way with many trading only a few cents wide and several are the most actively traded securities in the business. Based on this and the user-friendly nature of FROs, I am optimistic that the quote spreads will narrow.
Bumps like these tend to smooth out as liquidity in the product increases. The golden rule of liquidity works like this: the more liquid the stock, the more liquid the FROs based on that stock should be. That's why the Amex limited their FROs pilot to 20 extremely liquid stocks with good volatility and high investor interest. As additional institutional traders and brokerages bring more order flow to the product, liquidity should continue to improve. Increased liquidity usually has the effect of narrowing spreads, and making it easier to get your order filled, at tighter prices.
That said, staring down the barrel of a wide bid-ask spread or waiting to have your order filled can be frustrating. As markets in FROs grow, I'd suggest you stick to limit orders and adjust them as often as necessary. You might also have to experiment a little to see how close to the midpoint the market makers in your given FRO will move off their own bid and ask.
Think of it from a market maker's perspective when setting bids and asks: their sell price is the ask and their buy price is the bid. So if a trader like yourself sends a buy price out there that's better than the market maker's buy price (bid), then the bid moves up to your buy price - you are indeed in this case moving the published quote. This then means that if a sell order were to come in, you would be the first in line to get your buy order filled. Another way to think about bids and asks: if you see the bid move after your buy order is entered, it usually means the market maker is not willing to trade at your price, but wonders if someone else in the world will. Usually they'll test that theory by displaying your price to the rest of world to see if there are any sellers out there at the new bid price. This type of dance is new for beginners, but you'll get the rhythm if you observe things over time. In all cases, though, the more volume the better the chances of getting a fill.
As you've seen, volume doesn't usually arrive overnight with new products. While many brokerage firms are working to be able to offer access to FROs, right now, TradeKing is one of a very few leading firms that offer retail clients access to these securities today. As more firms come on-line, more customers will hear about them, which will lead to more volume. This combined with added institutional interest should make the FRO market environment more user friendly.
TradeKing Staff
Nicole's previous posts: FRO Trading Requirements and Using Delta to Trade Strangles
For a list of previous All-Star Trades, please click here.
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