Is gasoline going to $5 a gallon? Will the cost of corn and wheat continue to increase? Could the recent abysmal unemployment numbers make a turnaround in the coming months? Are things going to get even worse in the financial sector throughout the rest of the year?
Don’t just ask the questions — buy options to potentially profit from your answers.
There a million different ways to make money with options, and thanks to a group of financial services execs, now there are a million and one.
In May, a syndicate led by a team from the American Stock Exchange and the Chairman and CEO of TradeKing, Donato Montanaro, released the option market’s newest offering: Fixed-Return Options. Both call and put FROs are available.
Although it may sometimes feel that your options trades can turn out to be “all or nothing” in this crazy market, FROs actually are a “winner take all” bet. So get your Vegas money ready and learn a new way to trade.
AN EASIER WAY TO GET AN OPTIONS ‘FIX’
Most standard equity options have American-style exercise, in which the holder can exercise them at any time during the life of the contract. FROs are similar to index options, in that they have a European-style exercise, which means that they can only be exercised on expiration day. (Click here to learn more about different options exercise types.)
But where these instruments differ from traditional stock, equity or Exchange-Traded Fund options is that you either win or you lose come expiration day — there is no partial value.
As the name implies, they pay a pre-determined fixed amount (currently $100) and are automatically exercised if they are in-the-money. However, if they are out-of-the-money at expiration, the owner gets nothing. In this case, the prospect of option assignment — which tends to scare off would-be options traders who fear having stock “put” to, or “called away from,” them if they are on the losing side of a traditional option trade — is not even a consideration.
BINARY TRADES IN THE DIGITAL AGE
Fixed-Return Options are a class of equities known as binary options, which are essentially a yes/no investment that you either win or lose on your bet that housing prices, Consumer Price Index, weekly mortgage rates, crude oil futures, etc. will finish above or below whatever level you have picked.
They behave similarly to standard options, as there is an underlying instrument (i.e., stock, index, event), a strike price and an option chain in which you can select from various strike prices in both calls and puts.
But instead of trying to forecast where a particular stock, commodity, index or currency is going to be trading during a particular month and then identifying which types of options to buy or sell, you mainly have to pick the correct direction in which it will trade.
For example, the price of oil is either going up or down — and these days, many of us would probably put our money on “up”! — so your odds are 50/50 of being spot-on. You don’t have to guess exactly where it will end up; all you need to do is place your bets on red or black and then see where the ball stops on the wheel, so to speak.
If oil is trading at $130 a barrel, you might buy a call option at the $135 strike. If oil keeps reaching new highs, how high it goes doesn’t matter, just as long as it closes above $135 before the option’s time is up so that you can pocket your $100 win.
>
ANOTHER WAY TO PROFIT WITH OPTIONS
Binary options alleviate some of the need to have a solid trading strategy that’s normally associated with trading options. However, if you decide to trade them, they should only be a part of your overall options trading strategy. Unfortunately, they do not give you a shot at doubling or tripling your investment, nor can you use them to protect an existing stock position, like you can by buying and selling puts and calls the traditional way.
Although binary options have been traded Over the Counter (OTC) for many years by mostly bigger institutions and hedge funds, their emergence on the Amex brings a certain level of safety through regulation that aims to appeal, and to further open up the options markets, to newer traders who are eager to start trading options.
FROs give you a lot of power because buyers determine their own strike price. Another benefit of binary options lay in the fact that, contrary to traditional options, binary options’ values actually increase the closer expiration becomes.
CROSSING THE ‘FINISH’ LINE
Another attractive feature of Fixed-Return Options is that the risk-versus-reward structure is defined from the moment you enter the trade. However, there is a gray area to this black-and-white style of trading.
There are two types of FROs: Finish High and Finish Low. For long calls and puts, the most you can make is the fixed $100 (less commissions), and for short positions, the maximum loss is that same $100 minus any premium paid to the seller.
Using our crude oil futures example, if oil closed at $135.50, your $135 call would “finish high.” If crude closed at $134.99, however, it would have “finished low” and your contract would expire worthless.
READ THE FINE PRINT BEFORE YOU TRADE
Before you decide whether this “all or nothing” strategy is right for you, it’s important to note that in-the-money and out-of-the-money determinations aren’t based upon the underlying stock’s closing price, but instead on a volume-weighted average price, or VWAP.
The VWAP is a trading standard frequently used in pension plans, and it’s calculated by adding the dollars traded for every equity’s transaction (which is the price multiplied by number of shares traded) and then dividing by the total shares traded during the day.
The settlement value is determined by the Amex FRO Settlement Index (AFSI). With standard options, the option’s value is based on the underlying’s closing price on expiration Friday. But with the AFSI, which uses an average price instead, a trade you expect to work in your favor might not, whereas a trade you aren’t so certain will be in-the-money just might be determined to be that after all.
Further, FROs aren’t available on every traditional optionable stock or ETF. But considering that this investment instrument is less than a month old, there’s an extensive list from which to choose, including Apple (AAPL — FRO symbol AXO), JPMorgan Chase (JPM — FRO symbol LIV) and iShares Russell 2000 Index Fund (IWM — FRO symbol DNZ), among many others.
While FROs aren’t available through all brokerages, you can purchase them through TradeKing, as well as optionsXpress.
If you enjoyed this article, check out Dawn Pennington’s “Put a ‘Choke’ Hold on Profits” and “Generate Real Profits Synthetically.”
