Saturday, May 24, 2008

A little (very little, actually) on fixed-return options

One can use FROs to create a variation on a covered-call strategy. It would be akin to selling a call spread, as it allows you to collect premium, but also provides unlimited upside once the stock price moves above the option's strike price.

One way to take advantage of the limited-risk aspect of these options that are essentially a spread -- that is, it has limited risk -- as one can sell more calls than the number of shares you own.

In this sense, one could integrate FROs into an existing portfolio. For example, let's assume you have been riding the energy wave by buying the Oil Services HOLDRs (OIH) exchange-traded fund. With the shares currently trading around $210, one can sell the June 220 call for around $6.20 a contract. You can see the option chain by going to the Amex of the Web site.

But I think the real value, and how FROs will ultimately be successful, is that it offers a very low-cost way to take speculative positions in some of the most popular stocks, but at minimal cost.

The names that infatuate people, such as Apple (AAPL) and Google (GOOG) skew toward a younger demographic, who through no fault of their own, tend to not have much risk capital available, to say nothing of trading experience in stocks or options. FROs can be a great stepping stone toward learning how markets price various trading instruments.

Let's say you love Google and Apple. If you wanted to buy 100 shares of those stocks, it would cost you about $55,000 and $18,000 respectively. OK, let's assume 50% margin and cut it half. That is still about $36,000 to take a relatively small, and highly risky, position in just two names. Assume each stock gains 10% in the next two months. You would make about $7,300. That would be awesome. If they dropped 10% you'd lose about $7,300. Bummer.

But if you anticipate a 10% increase in price, one can buy the Google July 590 FRO calls for a mere 30 cents, or $30 a contract. This compared to buying the standard calls, in which the July 590 strike is trading around $7, or $700 a contract.

If Google is above $590 at the July expiration, the FROs will deliver a maximum of $70, or 120% profit. And while the standard options have an unlimited profit potential, their breakeven point is $597, or some 1.2% higher than the FRO of the same strike; they are also subject a greater impact of time decay and changes in implied volatility. Note that both options can be sold at point prior to the expiration date.

Trading options has a never-ending learning curve, which only seems to get steeper the higher you climb. I think FROs offer a path for people taking a first step by placing real money behind their opinions, but not having to worry that a misstep will prove fatal.

1 comment:

d said...

What's the deal?