You may have come across the term FRO recently while visiting your brokerage account or reading any recent financial newsletters. FRO’s are ‘Fixed Return Options’, a new form of derivative trading vehicle that share various similarities to standard stock options, but also have distinctive differences.
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Similarities
-FRO’s are linked to a specific underlying security as are standard stock options.
-FRO’s have a set strike price, as do standard stock options.
-FRO’s expire on the third Friday of the listed month, the same as standard stock options.
-FRO’s have a bid and an ask price, as do standard stock options. A FRO seller will most likely receive a premium equal to the listed bid price, a FRO buyer will most likely pay a premium close to the listed ask price.
-A FRO contract has a premium multiplier of 100, just as a standard stock option typically represents 100 shares per contract. Ergo, if the listed bid price for a FRO is $0.50, the investor will have to pay $50.00 to buy one FRO contract.
-An investor can close a FRO option anytime before expiration, just as a standard stock option can be closed any time before expiration.
-FRO options are European style which means they settle for cash, not stock, and they cannot be assigned before expiration.
Similar Differences, or Different Similarities
-There are two types of standard stock options: a call option and a put option. A call increases in value as the underlying security moves up, the put increases in value when the underlying security declines.
-There are two types of FRO’s: a Finish High FRO and a Finish Low FRO. A Finish High FRO is similar to a call option in that it will increase in value when the underlying security goes up. A Finish Low FRO is similar to a put option in that it will increase in value when the underlying security declines.
Differences
-A call or a put is determined to be In-the-Money (ITM) or Out-of-the-Money (OTM) based on the closing price of the underlying security.
-A Finish High FRO or a Finish Low FRO is determined to be ITM or OTM based on the AMEX FRO Settlement Index Value. This index represents the VWAP, or the Volume Weighted Average Price of the underlying security.
The Major Difference
-If a call or a put is ITM at expiration, the value of the option is based on its intrinsic value, the difference between the strike price and the stock price. For example, if an investor purchased a 50 strike call and the stock was trading at $55.00 at expiration, the call option would be worth about $5.00.
-If a Finish High FRO or Finish Low FRO is ITM at expiration, the value of the FRO is $1.00. If an investor paid $0.50 for a Finish High FRO, and the AMEX FRO Settlement Index Value was higher then the strike of the Finish High FRO, the investor would receive $1.00.
FROs are referred to as binary options as there are only two possible outcomes at expiration: The investor either receives a maximum profit or the investor realizes the maximum loss.
If I purchase a 50 strike Finish High FRO and the index settlement price is above $50.00, I will receive $1.00 for each purchased contract. My maximum gain would be the $1.00 I receive minus the initial purchase price of the FRO. If the index settlement price is below $50.00 at expiration, I receive nothing in return. My maximum loss is equal to the premium I paid for the FRO. Whether the FRO is 5, 10 or 20 points ITM at expiration, the most I can get back is $1.00.
If I sell (short) a 50 strike Finish High FRO and the index settlement price is above $50.00, I will have to pay $1.00 for each sold contract. My loss would be equal to the $1.00 I had to pay minus the initial premium I received. If the index settlement price is below $50.00 the Finish High FRO will expire worthless and I will keep the initial premium.
The same is true for the Finish Low FROs, with the exception that Finish Low FROs are ITM when the index settlement price is lower than the strike price. A Finish Low FRO is OTM if the index settlement price is above the strike price that was purchased or sold.
For a more detailed description about these new types of options:
FRO Specifications – (amex.com/options/prodInf/fros.specifications.pdf)
FRO Key Concepts: (amex.com/options/prodInf/fros.keyconcepts.pdf)
Comparison of FROs vs. Standard Options: (amex.com/options/prodInf/fros.comp.standard.pdf)
Concepts on the VWAP: (amex.com/options/prodInf/fros.settlementindex.pdf)
[tags] poweroptions, stock options [/tags]