by Dawn Pennington 08/06/08
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."
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