Why are all option strategies valued the 'European way'?

Discussion in 'Options' started by elsupremo, Nov 11, 2010.

  1. I don't get it...i admit that despite my 4 years experience in stock trading, i have little to no experience in options - but to the best of my knowledge - you can exit any option position at any time, as long as you're trading American options and as it seems - all cboe options + most forex otc options are american. Or...at least the big majority.
    So, this begs the question: Why many option strategies are explained in terms of profit AFTER expiry, for example...consider this strategy:

    1. You sell 1 option at the money, price - $2 - April 2011, call. Strike:
    2. You buy 1 option out the money, price $1, april 2011, call, strike: $35.
    3. If at expiry the price is $33 - then you will lose money, since you will have: +2-1-3.

    Yes, but then arises the question: What kind of idiot will wait until expiry - since the short option will have declined severly in value and the seller can get out buying back the option months before expiry? In a similar fashion - why would the buyer wait for her/his bought call to expire worthless since buying option out the money will be much more sensitive to upward price movements - even if this movement does not exceed the strike of the bought option (in the case above: $33 is less than the strike of $35 - but the option price might be much more expensive even in this case?).

    I guess the strategy given for example above is not so good example - but consider selling straddles - even then you can sell 2 years in front of you and get 2 times the volatility of the underlying (since you sell in both directions...) - you need to buy some put/call in the near term and exit all positions much earlier. Why not?

    What am i missing? The option gurus here probably can shed some light...
    Plus, in the straddle example above by the way - this is a delta neutral position, right? You don't have to worry so much for getting a margin call in such case?

  2. In general for books that discuss options trading it is much easier to focus on profit / loss at expiration. How can you show the reader what the profit / loss is at other times as easily, when the IV at the time isn't known? That being said, sometimes P/L charts do show dates such as 30 days til expiry or whatever.

    In other words, if you buy a 40 Strike Call for $200 - it is easy to say that at expiration if the stock is $45 it will be $500 because that is all intrinsic value - at say 2 weeks til expiry, it could be $550 or it could be $1000 depending on IV, etc.

    Delta-neutral at first won't save a short straddle from large losses on a large movement (it will no longer be delta-neutral).

    Option prices can vary widely before expiration as you have learned.

  3. MTE


    You can buy and sell all options at any time, not just American-style options.

    American style vs European style has to do with the ability to exercise an option not trade it.

    Options are a complex instrument so when presenting them to a person who knows nothing it is easier to present them on an expiration basis. Once the person grasps the basic concepts then you can start talking about prior to expiration.
  4. spindr0


  5. thanks, both answers are actually very informative...

    As for the delta neutrality, this is also something I've suspected...I mean it should be logical that in times of huge price movements in the underlying - the price of the option very roughly correspond to black-scholes. For instance, to the best of my knowledge the largest one day move of DJI is 20% downwards and 15% upwards - in such times of huge volatility it will be interesting to see what the real option prices are. Also...black-scholes seems to be flawed in many ways - one of which I've noticed so far is that the put price is sometimes lower than the call, due to the "risk free" rate - which while possible according to the model is never the case in practice. For instance, i am yet to see a put/call option whereas i can find
    at least 0.01 difference in put/call price per contract. Of course as a novice option trader i thought that i can become filthy rich in option arbitrage - but my enthusiasm faded even before i started :).
  6. MTE


    The problem is not Black Scholes or huge price movement when it comes to delta neutrality. The problem is that delta is an instantaneous measure, which constantly changes so as the market moves the delta changes as well. So a position that is delta neutral at a certain point in time can become delta negative or positive in a matter of minutes.

    The fact that put prices are equal to call prices is not a flaw of the Black Scholes model, but the result of the current zero interest rate environment. If the risk free interest rate is zero and there are no dividends then the time value of a put would be equal to the time value of a call. You can see it for yourself.

    In addition, in a Black Scholes pricing model (and others for that matter), volatility plays a critical role, and unfortunately, it is the biggest smudge factor in pricing. So your statement: "...I mean it should be logical that in times of huge price movements in the underlying - the price of the option very roughly correspond to black-scholes..." is a bit off. In any environment, you can use Black Scholes to arrive at a market price, it's merely a quesiton of inputting the correct volatilty number.