From: ask@cbnews.cb.att.com (Arthur S. Kamlet)
Subject: Re: what are stock options?
Organization: AT&T Bell Laboratories,  Columbus, Ohio
Distribution: usa
Date: Mon, 7 Sep 1992 19:07:13 GMT

In article <1685B8BFE.RKSHUKLA@SUVM.SYR.EDU> RKSHUKLA@SUVM.SYR.EDU (Ravi Shukla) writes:
>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.

This is basically correct.

The key is finding combinations of options/stock prices/etc that
-- with commissions figured in --  still result in making money.

Sometimes the commissions given to real big spenders (arbitraguers)
are sufficiently low that they make money while you or I will lose
money on exactly the same trades, because we have to pay higher
commissions.

It is very rare for "just folks" like me to be able to actually make
a profit through arbitrage.

>>   - What other group transactions are there and when do they make sense?
> 
>There are strips, straps, spreads, and other nice sounding combinations.

Anyone can try to create a straddle.  This is where you
simultaneously write a put and call on the same security and
are fully protected within a reasonable range of prices.
Straddles on other than ordinary stocks receive end-of-year
mark up tax treatment, though.

Basically, once you are truly comfortable with both buying and
selling both puts and calls -- and I'll tell you now I've been doing
this for quite a few years and am still not truly comfortable, then
preparing straddles is a matter of putting together a good looking
combination.

>>   - 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.

Correct.  You can generally put in limit orders and stop loss orders
which some brokers will honor.  (I don't think the exchange itself
gets involved, but I could be wrong.  My broker's trade computer
will accept these. orders.

The question is interesting, however.  You asked:

>>     how do I know how many options I can buy or sell at that price?

The actual question should be How do I know the price of a given
option?

Let's say the current price for IBM Oct 90 calls is $1

That means you can buy 1  of those calls  and pay $100 plus
commission (or sell 1 call for $100 less commision).

(Unless of course the price changes on you.)

Ordinarily 1 put or 1 call is for 100 shares of the associated
stock, except where stock splits/dividends have occurred and the
option and its price have been adjusted for the split.


You pay 100 x the price listed.

>>     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.

However, a market order is supposed to be executed when made.
That's the job of the floor trader.

>>  What is the cheapest brokerage company I can buy options from?

Don't know.  I have a "preferred client" account with Shearson
Lehman Brothers, meaning I do enough trading with them every year
that they give me a slight break on commissions.

I suspect without this break the commissions are higher.

I don't have a published commission schedule, but examples:
(Approximate, and subject to change)

  1 call  @ $1.25    commission = $28
  5       @ $1.25                 $58 

  1       @ $0.50                   9
  5       @  0.50                  20

  1       @ $3                     34
  5       @ $3                     74

In addition, Shearson tacks on a $3.85 fee for every trade!

(I have another broker who I do not do any options trading with,
because the company has a $50 minimum commission on every
transaction.)
-- 
Art Kamlet  a_s_kamlet@att.com  AT&T Bell Laboratories, Columbus
Newsgroups: misc.invest