Fixed Return Options (FROs) Offer Overlooked Shorting Opportunity

The dramatic series of policy decisions affecting our capital markets in the last week generally requires extremely nuanced discussion of the pros and cons, with one exception – the ban on shorting financial stocks. This is a complete perversion of free market principles and will do more to add to market inefficiency than anything else. Shorting is natural and helps the markets function by allowing people to take the other side of a trade, but the practice has unfortunately caught the populist wrath because it allows some to profit off the misfortune of others.

Regardless of one’s views of the new policy, it’s going to be a game changer for the markets, and smart traders need to trade the environment they’re in, rather than trade the environment they wished for. This ban on short selling select financials is going to cause the market to function in ways it hasn’t before, namely that the use of a “synthetic short” will cause traditional options to get much more expensive. A synthetic short is a combination of a long put and a short call, and offers the same payout structure as a traditional short stock position. Because this is going to become the main avenue to bet on a stock’s decline, the increase in demand will drive up the implied volatility cost.

The net result is that a regular options bet on a company might not be the most economical way to trade – savvy options traders know much more is built into a regular option price than just delta, or the directional component. And with artificially high implied volatility on regular options, a Fixed Return Option (abbreviated as “FRO”) might become the better choice for options traders in stocks like Citigroup (ticker: C), Goldman Sachs (GS), JPMorgan (JPM), and Wachovia (WB) – all stocks subject to the short-selling ban which have exchange-listed FRO markets.

Just because the government has stepped in to backstop the financial markets doesn’t mean to ignore the Finish Low FRO, either – in fact, it probably means you should zero in on potential opportunities there. On a weekly basis, the S&P was essentially flat. Does that make sense given the huge number of fundamental problems that have surfaced, and the time that will be required to resolve them? I’ve been skeptical of rallies in the financials, so this monumental effort to support them gives me pause, but I’m not about to go buy a basket of bank stocks. Too few institutions have deleveraged, or failed trying and either gone under or been consolidated out of existence, to make me think a bottom is in on the equity side.

In the meanwhile, keep in mind that implied volatility on options contracts is extremely high – and trading traditional options could be set to get pricier as short hedge funds and the like flock to the options pits to replicate bets against financial companies. Finish Low FROs are an underutilized tool that can provide a payoff similar to shorting, and could prove an invaluable addition to the trader’s toolbox in the coming months.

About Ernest Simmons