Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. |
Tom Gentile of Optionetics |
FROs
How do fixed return options work?
Fixed return options (FROs) are new contracts that recently started trading on the American Stock Exchange (AMEX). FROs are binary contracts that provide a payoff based on whether the equity or exchange traded fund (ETF) closes above or below the strike price of the option. It is similar to a flip of a coin -- heads you win, tails you lose. If you are correct, one contract pays $100. If not, the loss is equal to the premium paid for the contract.
As of this writing, FROs are listed on 20 stocks and Etfs. Each has a unique ticker symbol; for example, the fixed return options on Google (GOOG) trade under Tba, and for the S&P Depositary Receipts (SPY), the FRO symbol is SQY. The value of the FRO is based on an index computed using an average of prices and the settlement value is based on average prices on expiration Friday. The value at expiration might be different from the stock's actual closing price. These contracts settle European style and, consequently, can only be exercised at expiration.
Just as there are call options and put options, there are two types of FRO contracts: a finish high and a finish low. A finish high is a bet that the stock or ETF will close above a certain level. A finish low is a bet that the stock will close below a certain price.
For example, as of mid-May, Google is trading for $581 a share and an option strategist expected it to move above $600 by June expiration. The finish high 600 FRO (or call) is offered for 40 cents a contract. If the strategist buys the contract for $40 a contract (the multiplier is 100) and TBA finishes above $600 at June options expiration, the strategist gets a $100 payoff. Subtract the cost of the FRO and the profit is $60. If the Google FRO Settlement Index doesn't close above $600, the strategist will lose the initial cost of buying the contract, or $40 plus commissions.
A strategist could also sell the TBA June 600 Finish High FRO if they don't expect TBA to move above $600 by June expiration. Or they might buy a TBA June 570 finish low FRO if they expect the stock to fall below $570. Just as with a standard option contract, these options can be closed out before expiration through offsetting trades. If not, in-the-money options will be settled for cash, or $100 per contract. Out-of-the-money FROs expire worthless. Other specifications and educational material are available at www.amex.com.
PUTS, CALLS, AND PARITY
What is put-call parity? Is there a way to profit by it?
Parity is equality in amount or value. In the option market, parity refers to the fact that certain relationships must hold or it will create an opportunity to make a risk-free profit. At expiration, at-the-money puts and calls, or options with strike prices equal to the price of the underlying stock, will have the same option premiums. If not, it would create a risk-free arbitrage opportunity. If the puts are trading at a premium to the call, it would be possible to make a risk-free profit by selling the put and buying the call and, in essence, creating a long stock position. To capture the difference in premiums with zero risk, the strategist can sell short 100 shares for each put.
If there is time left until expiration, the situation is somewhat more complicated because of the impact of dividends and interest rates on premiums. Interest rates make shares for future delivery more expensive. If you're a market maker and need to lock in a price for delivery in three months, you must borrow the money for the stock and pay interest on that money for three months. So higher interest rates result in higher stock prices for futures delivery, greater call premium values, and lower put prices.
Dividends have the opposite effect -- lowering the value of calls and increasing the cost of puts. In most cases, the prevailing interest rate is higher than the dividends and puts will trade at lower prices compared to calls when the stock is at the strike price and time remains until expiration. If you pull up an option chain and, all else being equal, the puts are trading at lower prices to calls, you are seeing the effect of interest rates.
After taking into account dividends and interest rates, put to call
parity yields equalities that are worth understanding. The first we already
discussed -- buying calls and selling puts is the synthetic equivalent to
holding stock:
Buy call - Sell put = Long stock
Conversely, selling calls and buying puts is the synthetic equivalent
of shorting stock:
Long put - Short call = Short stock
Meanwhile, three other relationships also hold because premiums
for puts and calls with strike prices equal to the stock price should be
equal (excluding the impact of interest rates and dividends):
Long stock + Long put = Long callShort stock + Short put = Short callShort stock + Long call = Long put
Now, understanding these relationships is great, but is there a
way to make money from it? In most cases, no. Although market makers can
take advantage of situations when put-call parity is violated, it is
difficult for the individual investor. However, understanding these relationships
can help make important strategy decisions. If you are considering buying
shares and protecting those shares with puts, why not simply buy calls
instead? The payoff is the same, but the call option requires a lot less
capital.
Originally published in the July 2008 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2008, Technical Analysis, Inc.
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