From: RKSHUKLA@SUVM.SYR.EDU (Ravi Shukla)
Subject: Re: what are stock options?
Organization: Syracuse University
Date: Mon, 7 Sep 92 10:27:24 EDT

In article <1992Sep7.074709.23610@cs.umb.edu>
sasha@ra.cs.umb.edu (Alexander Chislenko) writes:
 
>   I have some more questions on options:
>
>   - What are arbitrage transactions?
 
Theoretically, an arbitrage portfolio w is such that w'1=0 (zero total invest-
ment), w's=0 where s is a vector of risk elements (so that total risk is 0),
and w'r>0 (total expected return is positive). Transactions that result in
such arbitrage profits are arbitrage transactions. It is nearly impossible
to create arbitrage portfolios using stocks only. Combining options,
the underlying stocks and the Treasury bills (or some other default-free
investment) one can create arbitrage portfolios. Of course, prices also have
to cooperate. The most popular example of arbitrage transaction is through
the violation of put-call parity. A portfolio made up of long position in a
put, short position in a call, and a long position in the underlying stock
is a perfectly default-free (may be even risk-free) portfolio if the put and
call have the same maturity date and strike prices. The payoff on this
portfolio will (under all circumstances) be equal to the strike price (this
is strictly true only for the European type options, but let me continue).
Therefore, a Treasury bill with the face value equal to the strike price
must be selling at a price equal to the price of the put-call+stock portfolio.
If not, we have an arbitrage opportunity. Depending on which is priced cheap,
you can buy it and sell the other one, wait till maturity and make an
arbitrage portfolio. Of course, the price difference has to be sufficient
to cover the transaction costs involved.
 
>   - What other group transactions are there and when do they make sense?
 
There are strips, straps, spreads, and other nice sounding combinations.
 
>   - Suppose the broker tells me that a current option price is X;
>     how do I know how many options I can buy or sell at that price?
 
The option prices can change between price reporting and actual transaction
just as the stock prices. Other that that there is no major difference.
 
>     Or X is just a price for previous transactions, and I'll have to
>     wait for hours until the market price settles?
 
You just have to wait till there is a buyer/sell to take opposite position on
your option.
 
>  Is there any book you can recommend on option trading?
 
From the trading perspective, there are two good books:
1. Gastineau, The Options Manual, McGraw Hill
2. ?        , Option as a Strategic Investment, New York Institute of Finance.
 
For a rigorous analysis of options, I recommend the following:
1. Cox and Rubinstien, Options Markets, Prentice-Hall.
2. Stoll and Whaley, Options: Theory and Practice, Southwestern.
3. Ritchkin, Options: ? ? ?, Scott-Foresman.
>
>  What is the cheapest brokerage company I can buy options from?
>
That one I don't know. Because I haven't traded options yet!
 
>
>Could somebody answer at least some of these questions?
 
Ravi Shukla
 
          ++==============================================++
          || Ravi Shukla                                  ||
          || Department of Finance, School of Management  ||
          || Syracuse University, Syracuse, NY 13244-2130 ||
          || rkshukla@suvm                                ||
          || (315) 443-3576                               ||
          ++==============================================++
Newsgroups: misc.invest