Lessons from the Pros

Farewell to the FROs?

**HEAR IT HERE FIRST**

While I can’t be absolutely certain, it looks to me like the Fixed Return Options, affectionately known as FROs, are not going to be continued. While I haven’t been able to get official confirmation from my contacts at the American Stock Exchange, the evidence is that new expiration months and strike prices are not being added and there appears to be little interest from either the public traders or the market makers.

These options, which started trading on May 8th of this year, have not been as well received as originally anticipated. You may recall that FROs are binary options that are worth either 0 or $100 at expiration. As I see it, there are several reasons for the apparent demise of this product.

First, to trade FROs you need to learn a new set of terms. Instead of just calling them Puts and Calls, FROs are referred to as Finish Low, or Finish High options. Also, there was little to no need for having both of these, since selling a Finish High is equivalent to buying a Finish Low (think about it.)

Second, the spreads are just too high, typically 25 cents. This is for an option that trades between 0 and 1! So for an option priced .60 x .85, if you’re trading with market orders, you need a 42% increase in the option price just to break even. As an ex-market maker I know that part of the problem of setting the spreads and pricing these options is that it is difficult, if not impossible, to find an appropriate hedge for them, because of the large discontinuity at the strike price. For example, 1 Finish High FRO with a strike price of $150 at expiration is worth nothing if the settlement value is $150 or less and $100 if the settlement value is greater than $150. A one penny difference in the settlement value can make a $100 difference in the value of the option. (Think about that in delta terms.) That’s very different than regular options where the expiration value is either $0 or moves dollar for dollar with the underlying stock price. See the following graph of a FRO purchased for 30 cents:

Third, again in my opinion, the FROs weren’t advertised and marketed aggressively enough. The marketing budget at the American Stock Exchange was simply not large enough to make the public aware of this product. Many traders that I speak to are still unaware that FROs are being traded. (Of course, Online Trading Academy students knew about these options almost from day one!)

Fourth, many large brokers did not offer them, so a large portion of the public was unable to trade FROs even if they wanted to. I contacted several of these brokers and found two main reasons; their computer systems could not handle the margin requirements and would need to be re-programmed, and also that the CUSIP numbers assigned to the FROs by the Options Clearing Corporation are the same as those assigned to the regular options. This caused additional programming and other technical issues for the back offices. It is interesting to note that many of the smaller brokers specializing in options were able to meet the challenges and started trading FROs from the start.

Fifth, these options only trade on the American Stock Exchange and the volume is very light. Suffice it to say that when I traded a FROs position in Apple (FROs symbol AXO) I was the entire volume that day for the expiration month I was trading!

Sixth, the settlement value at expiration is based on a settlement index and not the actual closing price of the stock. For example, let’s say you’re long 1 XYZ Finish High 150 FRO. On expiration day if XYZ closes at $150.50, you would expect the option to be worth $100. However, it is possible that the XYZ settlement value closes less than $150, say at $149, and your option is worth 0. Of course it could work the other way as well with XYZ closing at, say $149, and the settlement value being $151 making the value of your option $100. I’m not arguing with the idea of using a settlement value, there are many good reasons to do so and it reduces potential manipulation, I’m just saying that it makes the product more complicated for the less sophisticated trader.

Finally, with the NYSE Euronext acquisition of the American Stock Exchange and the consequent change in personnel, the issue of FROs appears to have been put on the back burner. The management of the options department has a lot of issues that need to be addressed and resolved to make the acquisition a smooth one.

If I’m right, the FROs will just faze out over time. In my opinion, this is unfortunate since it seems to me that the concept is a good one and that if done properly there would be many benefits to the trading public. In fact, as you probably already know the Chicago Board Options Exchange has already come out with their version of binary options on the S&P 500 and the VIX and is anticipating additional products in the near future. Perhaps, after the dust settles the American Stock Exchange or some other competing exchange will allocate the time, effort and resources necessary to develop a workable binary options product and they will reappear.

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.

- Stan Freifeld