Understanding Fixed Return Options: Part Two

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...continued from Part One

OPTION GUYíS TIP: If the settlement value is ìpinnedî exactly at the strike price at expiration, FROs are considered to be out-of-the-money and they expire worthless. Obviously, that will favor the FRO seller over the buyer. However, since the settlement value and the strike price will rarely be exactly equal, itís only a small advantage for the seller.

HOW THE ìAMEX FRO SETTLEMENT INDEXî VALUE DETERMINES WHETHER FROs ARE IN-THE-MONEY OR OUT-OF-THE-MONEY
Hereís where Fixed Return Options get a little tricky. Settlement value for the underlying stock is determined differently than that of standard options. Settlement for calls and puts is usually determined by the underlying stockís price when the market closes on the expiration date.

But whether an FRO is in- or out-of-the-money is determined by calculating the stockís AMEX FRO Settlement Index value. This is the Volume Weighted Average Price, or ìVWAP,î on the day the option expires.

In case youíre not familiar with the term VWAP, itís calculated by adding up the dollar value of all trades on a given stock on a given day, and dividing that sum by the total number of shares traded. In other words, VWAP is a fancy way of saying ìthe average dollar price of a specific stock on a particular trading day.î


The VWAP is calculated and disseminated at 15-second intervals throughout every trading day. Only trades that occur while the markets are open factor into the VWAP. Pre-market trading and after-hours activity do not affect the figure.

The AMEX FRO Settlement Index value is the final VWAP calculated after close on the FRO expiration date. This will usually be posted within 2 hours of the close. Itís important to note that the AMEX FRO Settlement Index value will usually not be exactly equal to the stockís closing price at expiration.

And that serves an important purpose. The reason the VWAP is used for settlement at expiration instead of the closing price for the underlying stock is to prevent any large (and unscrupulous) financial entities from manipulating the stock price near the end of the trading session.

Since FROs are an all-or-nothing trade, and a one-cent increase or decrease in share price can potentially make the difference between receiving $100 per contract and receiving nothing, itís essential to guard against
price manipulation.

OPTION GUYíS TIP: In case youíre a stickler for correct pronunciation of financial terminology, in the brokerage world VWAP is usually pronounced, ìVEE-whop.î

continued in Part Three...

posted by: Trade King
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