Lawrence McMillan gives us the inside line.
The new Fixed Return Options (FRO) should be an interesting and exciting new product for speculators. A FRO is a binary option, meaning it is worth either $100 or $0 at expiration - nothing in between. Clearly, one would pay less than $100 for the option and, if it finishes in the money, his profit would be $100 less whatever he paid for it. Readers are directed to the explanatory documents produced by TradeKing and or the AMEX, for further information on the details of these contracts.
Binary options are not a new concept. For example, they are in use in many places in society today. Any question that can be answered with a simple "yes" or "no" could be the object of a binary option. For example, will the Giants win the Super Bowl next year? The outcome is easily identifiable as "yes" or "no." In Las Vegas, one can place wagers on whether or not the Giants will repeat. If one were to place wagers on the outcome of that event, he would be in effect trading a binary option.
These FROs differ from that description in one major way, though - they will trade continuously in a secondary market, giving you the opportunity to take profits or cut losses without having to wait until the actual event outcome is known.
FROs will eventually be offered on over 70 regular stocks (20 are in the initial offering), and they will have expiration dates equal to regular stock options. Their striking prices will be similar as well.
There are some differences between regular options and FROs. First, the nomenclature for calls and puts has been changed to "Finish High" and "Finish Low" respectively.
Just as a quick example, if you own a Finish High FRO on IBM with a striking price of 115 for May expiration, then the FRO will settle with a value of $100 if IBM finishes at 115.01 or any price higher on its expiration date. An IBM May 115 Finish Low FRO would be worth $100 at expiration if IBM were at 114.99 or any price lower. If IBM finishes exactly at 115, both the Finish High and the Finish Low would expire worthless. (This scenario would be akin to the outcome of "double zero" on a roulette table for a FRO buyer.)
Also, FROs do not use the actual price of the underlying at expiration to determine if they are in-the-money or not. Rather they use a technique called "Volume Weighted Average Price" (VWAP). This prevents manipulation.
For example, in the case of a regular stock option, if some nefarious block trader were to push IBM from 114.99 to 115.01 right before the bell on expiration Friday, he wouldn't gain much. If he owned call options they would only be worth 0.01. However, in the case of a FRO, a movement like that would change the worth of the IBM FRO with a strike of 115 from $0 to $100! Quite a change. The use of VWAP pricing effectively eliminates that, for VWAP is the average price of all trades that have taken place all day long on expiration Friday. So, by the time one gets to the close, it would take a tremendous amount of capital to move the VWAP of a liquid stock.
Use in Spreads
In some sense, owning an FRO is a bit like owning a bull spread or a bear spread whose striking prices are one point apart, because there is limited profit potential and limited loss potential. FROs can be sold as well as bought, in an opening transaction. So, selling a FRO - especially an out-of-the-money one - can be considered similar to selling credit spreads. When you sell the FRO, your margin requirement would be your risk - just as is the case with selling a credit spread.
However, they are not completely like bull or bear spreads. Consider this example: suppose, XYZ, with striking prices one point apart. Furthermore, suppose you can set up the following in regular XYZ options:
Buy 1 May 15 call
Sell 1 May 16 call for 10 cents debit
And also:
Buy 1 May 17 call
Sell 1 May 16 call for 10 cents credit
Combined, these create a butterfly spread for no debit:
Long 1 May 15 call
Short 2 May 16 calls
Long 1 May 17 call
Now, compare that with:
Buy XYZ May 15 FRO for 10 cents
Sell XYZ May 16 FRO for 10 cents
If the FRO were exactly the same as a bull or bear spread, these two positions would be the same, but they are not. Figure 1 shows the two profit graphs. They are not similar at all.
Click here to view a larger image.
To verify this, break it down in segments:
- If XYZ is below 15, both the Finish Highs expire worthless, and the profit is the initial credit or debit, which was zero.
- If XYZ is above 15 but below 16, the 15 Finish High is in the money and is thus worth $100, while the 16 Finish High expires worthless - a total profit of $100.
- But for any prices above 16, both Finish Highs are in the money, and so the long would be worth $100, but the short would cost you $100, and thus your profit would be zero.
So, if you are thinking of spreading these, be very careful in your computations, for they do not relate well to spreads as you might normally think of them.
The Greeks
Before finishing, let me insert something about theoretical valuations and "the Greeks" for these options. There are models for them (see Options Futures and Other Derivatives, 5th edition, John C. Hull). And thus, greeks can be computed. However, as expiration approaches, if you own one of these, you will get a new appreciation for the word "volatility." Suppose as the trading day is winding down that the VWAP for XYZ is 14.97. The Finish High call might be trading at a low price, say 15 cents. But if some large buyers appear (perhaps on the close on expiration day, as is sometimes the case), and XYZ moves up to 14.99, the Finish High might quickly move up to 45 cents or so, and then if XYZ moves up to 15.01, the Finish High might jump to 85 cents. The gamma of these options is huge, especially as expiration nears.
Summary
There is a lot more that can and will be written about these contracts, to be sure. Overall, these products should prove to be interesting for speculators, as their simplicity and "all-or-nothing" approach will appeal to many. Just be careful if you try to spread them, or try to get "fancy," for - when combined - they don't always conform to what your mind might expect from conventional option strategies.
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Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
The Greeks (Delta, Gamma, Theta, Vega, and Rho) represent the consensus of the marketplace as to the how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that these forecasts 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.
