A new form of stock option is now available to the general investing public. Called fixed return options (FROs), these new options provide a useful new alternative previously only utilized by institutional traders. FROs were first listed on the exchange in May of 2008. They are referred to as “binary options” which have fixed “all or none” outcomes.
The terminology might seem complex, however FROs are actually quite simple. All FROs pay $100 per contract if the underlying event occurs. If the event does not occur, then the value of the option is zero. Hence, the “all or none” moniker.
Just as with traditional options, these FROs have stated expiration dates and strike prices. For example, assume stock XYZ is trading at $25. FROs would be issued at various strike prices for both puts and calls like normal options. However, the option assumes a par value of $100 if the strike is hit upon expiration.
It does not matter how much the stock exceeds the strike price with an FRO. With the above example, let’s assume we’re looking at a $35 call FRO expiring within a month. A good assumption for the value of this FRO would be no more than ten cents. A stock going from 25 to 35 in less than a month is a tall order.
A ten cent FRO price can be extrapolated to a 10:1 pay off. $10 invested per contract pays off $100 should the event occur. This event being XYZ stock closing above $35 on the day of expiration. This presents an alternative way to trade when you foresee strong and rapid movement in a given stock.
Previously, you would have had to buy the 35 call and pay the premium associated with it. Then you needed the stock to go sufficiently above 35 yielding enough to cover the premium plus significant additional return to justify the high risk incurred via purchasing far out of the money options.
FROs allow for a defined and substantial return solely for hitting your strike. It doesn’t need to go a penny above it. With the above example, if XYZ closed at 35.01 the 35 strike FRO call holder would experience at least ten to one return on investment. The holder of a traditional 35 call would lose virtually all of their investment. This obviously is a dramatic difference.
However, the FRO does not pay off as significantly on the extreme upside. The FRO is limited to $100 value for each contract. Traditional options have theoretically unlimited gains. FROs are consequently more conservative than normal options. An FRO holder is willing to sacrifice some upside in order to lock in maximum returns just upon hitting the applicable strike price.
FROs can be used both for speculation as well as for position protection. They can be akin to married puts or covered calls. However, in many instances they can prove far more efficient depending upon the premium prices quoted on the traditional options. One can also foresee sharp traders devising arbitrage opportunities between the FROs and normal options on the same underlying stock.
FROs represent a new and exciting world for individual investors. Educational resources are starting to appear on the Internet, and further information is most probably available from your broker. A good trader needs every weapon at their disposal. Don’t let this one remain out of your arsenal.