Understanding Fixed Return Options: Part Three

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...continued from Part Two



LETíS SEE AN EXAMPLE OF VWAP IN ACTION
Imagine stock XYZ trades in a range between $24.00 and $25.50 on the FRO expiration date, before closing at $25.25. The total value of XYZ shares traded throughout the day is $24,990,000, and there were 1,000,000 shares traded. $24,990,000 divided by 1,000,000 equals $24.99.

So thereís your final VWAP, or AMEX FRO Settlement Index value. Because stock XYZ closed at $25.25, a call option with a $25 Strike Price would be 25 cents in-the-money and the option would most likely be exercised. However, if you owned a Finish High FRO with a $25 Strike Price, it would expire worthless because the AMEX FRO Settlement Index value is only $24.99.


And youíd probably like to say a few things that might get your mouth washed out with soap. On the other hand, if you owned a Finish Low FRO with a $25 Strike Price, even thoug h the stock closed above $25 at $25.25, youíd still collect a $100 fixed return thanks to the VWAP.

And then youíd probably do a little happy dance while feeling like you dodged a bullet. Over the long term, using the VWAP to determine the AMEX FRO Settlement Index value instead of the closing price does not favor High Finish or Low Finish FROs, and it does not favor either FRO option buyers or sellers.

Sometimes the VWAP will be higher than the closing price, and sometimes it will be lower. So it all comes out in the proverbial wash. The VWAP is simply used to ensure that all FRO contracts are settled fairly and are not subject to price manipulation on the underlying stock

Continued In Part Four...

posted by: Trade King
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