European Style Stock Options

Abstract

We have seen in Chapters 1 and 2 how different it is to invest in risk-free assets than in stocks. Going down the line of available financial instruments chosen for consideration in this book, we come to the study of stock options. There exists a further fundamental difference between stocks and options, and consequently, even much more of a difference between risk-free investing and options trading. The fundamental difference between stocks and options is that options have quite complicated dynamics, are much more volatile, and moreover, have a limited life time. As a matter of fact, options usually have a very limited life time. Options are available with expirations of up to eight months on over 1700 stocks, and for over 200 stocks as far in the future as three years; nevertheless, the most liquid options are those which expire sooner rather than later, and consequently the old fashioned buy and hold strategy obviously is almost never an option. On the other hand, although individual options by themselves are extremely volatile, i.e., risky, the price movements of different kind of options on the same underlying stock, as well as of the price movements of the underlying stock, are almost perfectly correlated, positively or negatively. That fact alone can be exploited for constructing various trading strategies that have the objective of actually reducing or even, at least theoretically, eliminating the risk involved in investing rather than increasing the upside potential aggressively.