Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!

A New Financial Instrument

This week I was doing some more traveling and was preparing to write an article on expiration day trading since tomorrow is expiration day for the May options. However, last week the American Stock Exchange (that's where I was a Market Maker for 8 years) started trading a new product; binary options. Since I want our Online Trading Academy students to be some of the first public traders to know about this new product, I'll do the expiration day article at a later date and discuss this exciting new financial instrument today.

As I used to explain to students in the options course, there are only 2 types of options, Puts and Calls. (Failure is not an option.) Well, now there are 3! On May 1st the AMEX announced that beginning May 8th, last Thursday, it would start trading a new type of option called Fixed Return Options or FROs for short. This is just a fancy name for binary options. Binary usually refers to something that can exist in 1 of 2 states, in this case, the 2 states are "worth $100" or worthless. I have also heard FROs referred to as "cash or nothing" options.

There are 2 types of FROs; High Finish and Low Finish. They are somewhat analogous to Calls and Puts, respectively. I'll give a quick explanation, and then I'll flesh out the details in the rest of the article. If a High Finish option or a Low Finish option is in-the-money (ITM) at expiration, then it's worth $100. Otherwise, it's worth nothing. So if we buy 1 XYZ High Finish July 25 FRO for $45, it will be worth $100 if XYZ is over $25 at July expiration and therefore make a profit of $55. However, if XYZ is $25 or lower, the FRO will expire worthless and we will lose the entire $45. It's actually a pretty simple concept, although some of the details are a little bit tricky.

Last week 20 FROs started trading and it is anticipated that many more will be introduced in the future. For now the list is composed of 12 stocks and 8 ETFs as follows:

The FROs will trade with the same strike prices and expiration dates as the underlying stock or ETF. The exception being that LEAPS FROs will not be traded, at least for now. A complete FRO symbol will add the standard month and strike price code to the FRO symbol shown in the table above. For example, the Intel July 25 High Finish and Low Finish symbols are IDPGE and IDPSE, respectively.

Just like regular Put and Call options, you can open a position by either buying or shorting a FRO. The position can be held to expiration, or can be closed prior to expiration. These FROs are all European style exercise, meaning that they can only be exercised at expiration and the exercise will happen automatically, you don't have to call your broker. If they're ITM they get exercised and if you're short, you will be assigned. Notice that they settle in cash. In other words, no stock changes hands, only cash. Also, you don't have the issue of unlimited potential losses when you are short a FRO as you do with Put and Calls. On the other hand, you don't have the possibility of unlimited gains either.

Suppose it's expiration Friday and a large investor has a large position of XYZ High Finish FROs and the stock is trading right around $25, let's say $24.98 bid offered at $25.01. That investor might be tempted to pay up to push the price of XYZ over $25 if he is long, so that his FROs are ITM, and now worth $100. If he is short, then he may try to sell XYZ to keep the price under $25. To prevent that sort of manipulation, the AMEX came up with the idea of using an "FRO Settlement Index" instead of the closing price on expiration Friday to determine if the FRO is ITM or OTM. This Index is the Volume Weighted Average Price or "VWAP" of all the stock traded that day.

For example, if the following shares of XYZ traded on expiration Friday,

Then the VWAP would be equal to $632,113/25,300 = $24.98 and that amount would be used as the FRO Settlement Index to determine if the FRO is ITM or OTM.

Since this product is so new, there hasn't been much time to evaluate how the pricing will work. If you want to become comfortable with these FROs, I think it would be worthwhile to try to determine how each of the variables that are used to calculate the old fashioned Calls and Puts (stock price, time to expiration, volatility, risk-free interest rate, and dividends) impact the FROs. Next you can think about the Greeks, and how they differ from the Greeks on Puts and Calls.

I am sure that many professional traders are spending lots of time analyzing these FROs to determine if and how they can be used for arbitrage trading, speculating, hedging, etc. It is expected that this new instrument will become a huge product as time goes by and they become better understood. Learning about them at this early stage in their development can only lead to more opportunities in the future. I'll keep you posted of any new developments.

As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: sfreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.

11. Know Thy Options!

DISCLAIMER:
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

Reprints allowed for private reading only, for all else, please obtain permission.