Trade in Groups

Fixed Return Options (FROs) are a new type of exotic options, however don’t let ‘exotic’ scare you - it doesn’t mean FROs are complicated. In fact they’re really simple, they are just a bit different from standard put and call options.

FROs are binary options, meaning there are only 2 possible outcomes. They offer a fixed return of $100 per contract. That means buyers of FROs that expire ‘in the money’ receive $100 per contract, and sellers of the FROs that expire in the money are required to pay $100 per contract. Buying FROs are an all-or-nothing trade.

Here are a few examples of traditional option trades, so that you can better understand the difference:

The Long Call (Traditional)

With a Long Call, you are betting the stock is going to go way up. This allows you to profit if the stock goes up, but limit your risk if the stock goes down. It is also used to gain leverage, or a larger number of shares (because you don’t need to buy the actual shares). The risk is that options can expire worthless, while a stock would still likely have some value.

The Long Put (Traditional)

The Long Put gives you the right to sell a stock. You are betting that the stock is going to go down. It is an alternative to selling a stock ’short’. It actually lowers your risk because if the stock goes up, which is a worse-case scenario, you don’t have to deliver shares to an investor whom you’ve borrowed them from.

The Finish High FRO

The Finish High FRO are in-the-money at expiration if the settlement value is at least one cent higher than the Strike Price, and out-of-the-money if the settlement value is equal or less than the Strike Price.

The Finish Low FRO

The Finish Low FROs are out-of-the-money at expiration if the settlement value is at least one cent lower than the Strike Price, and out-of-the-money if the settlement value is equal or less than the Strike Price.

It is important to note that the settlement value is actually based on an avearge for the day, not the closing price. Because just 1 cent in either direction could be the difference between a $100 per contract profit or a $100 per contract loss, AMEX creates each stocks AMEX FRO Settlement Index value, which is the volume weighted average price for the day the option expires. This is to prevent fraud.

FRO Summary

Fixed Return Options (FROs) have a limited and known profit and loss potential. Therefore, an investor can limit his or her potential for loss and or gain. Currently, FROs are available on AMEX and can be traded via TradeKing.

Some of this information is based on information provided by TradeKing , who also has a great free white paper that will educate you on how to trade using FROs.

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