A new option concept recently debuted on the American Stock Exchange (AMEX). So-called Binary or Fixed Return Options (FROs) were listed on the twelve liquid US stocks and eight ETFs. I will write a more in depth article on the subject which will be posted at http://www.m-x.ca/marc_options_articles_en.php during next week.

Because many concepts that are launched in the US come to Canada, I wanted to provide readers with a very brief overview, and as the title suggests, talk about one specific strategy using FROs.

Fixed Return Options are very different from traditional options. To the point that the AMEX has defined new terms to describe the option types. Rather than puts and calls, the FROs are defined as “Finish Low FROs (puts)” and Finish High FROs (calls).”

Traders can visit the AMEX Web site (www.amex.com) for details on the intricacies of the product. On the lower right of the AMEX home page, under the heading Spotlight, click on Fixed Return Options. That brings you to a page with two tabs: Introduction and Educational Material. There is also a link to Contract Specifications in the middle of that page.

Think FRO… think delta

Essentially an FRO tracks the options delta. The delta is a derivative of the option pricing formula and basically, defines how much the option is likely to move given a $1.00 move in the value of the underlying stock.

Say XYZ is trading at $50 per share and the XYZ June 50 call is trading $1.45. Assuming 20% implied volatility, the XYZ June 50 call would have a delta of 0.545. Which is to say, the XYZ June 50 call would be expected to move by $0.545 for every $1.00 change in the value of XYZ. Delta is not a static measure. If an option moves in-the-money, delta increases, and vice versa.

Since the value of the FRO is effectively the option’s delta, the XYZ June 50 Finish High FRO would be trading at some price between 54 cents and 55 cents. At expiration, the XYZ June 50 Finish High FRO would either be in-the-money (i.e. XYZ closes above $50 per share) or out-of-the-money (i.e. XYS closes below $50 per share).

At expiration an in-the-money call, with no time value remaining, would have a delta of 1.00. Conversely, an out-of-the-money call at expiration would have a delta of 0. That is the basis on which the Finish High FRO is valued. At expiration the Finish High FRO in this example, will be worth either 1 ($100 per contract) or 0, nothing in between. Which, by the way, is where the generic term “binary” became attached to these products.

Whether the FRO is in-the-money or out-of-the-money at expiration is determined by the trading price and volume of the underlying stock on expiration day. Specifically, on how trading activity on expiration day impacts the AMEX FRO Settlement Index (AFSI). I talk about that in depth in the aforementioned posted article.

Finally, the value of the XYZ Finish High FRO between now and the June expiration will be determined by the change in delta over that period. As the stock rises, so does the delta, and by extension, does the price of the Finish High FRO.

An alternative to covered call writing?

One strategy that some covered call writers might find useful is to write Finish High FROs rather than deep out of the money calls.

When you think about covered call writing as a strategy, you collect premium income from the sale of a call option. The income provides some downside protection at the cost of limited upside potential. Traditional covered call writers tend to sell close to the money calls to provide a balance between downside protection and limited upside potential.

However, some covered call writers – call them over writers – prefer to write deep out-of-the-money calls, for which the premium received is small. Because deep out-of-the-money options don’t tend to produce much income, they are comparable to at-the-money Finish High FROs.

Lawrence McMillan at www.optionstrategist.com suggests that over-writers could sell a Finish High FRO, which would provide very limited downside protection – maximum downside protection would be capped at some value below US $1.00 – along the lines of what you might get writing a deep out-of-the-money traditional call option.

On the positive side, the sale of the Finish High FRO would not impinge the upside potential in the stock. If the stock rises, the Finish High FRO will be in-the-money, but the maximum loss would be $1.00 ($100 per contract) less the initial premium received. The loss incurred would have only a minimum negative impact on the return from the rising stock value, and since the FRO is cash settled, there is no physical delivery of the underlying shares.