Options are derivatives. That’s it.
They derive their value from an underlying asset, just like futures or swaps. (thanks for reading the article see you next time).
There is no shortage of people who turn options knowledge into 4,000-word essays packed with third-order Greeks charts, volatility surfaces, and enough jargon to make it feel like rocket science.
While these obviously have their time and place, I do not assume you plan to become a quant or options market maker.
For retail traders, naming all third-order Greeks and calculating the theoretical fair value of an option using the Black-Scholes Model in your head is more telling about your social life than giving you any trading edge.
Contrary to popular belief, understanding how options work is not an edge. Understanding what product you trade should be the bare minimum.
But you still need to know the mechanics before you can do anything useful with them. This article covers all the fundamentals: what options actually are, how they’re priced, what drives their value, and most importantly, when it makes sense to buy them versus sell them.
By the end, you’ll have a complete picture of how options trading works and enough context to start thinking about where real edges might exist.
Before we dive into the article, if you want analytics for over 1,000 markets across options, crypto, and futures while learning systematic trading strategies that harvest different risk premiums across multiple asset classes, check out tradingriot.com. Use code “ANALYTICS” for 50% off your first month.
Also, Twitter is unfortunately limiting the number of images that can be added for articles, that sucks for this one especially since there was quite a lot of them I had to exclude and some I had to group into gallery so they are little bit all over the place. You will find better version on blog.tradingriot.com
# What Is an Options Contract?
Before we go into any complex stuff, I figured it would be nice to give you an example outside of financial markets that completely covers options basics and Greeks.
Options give the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price on a specified date.
The buyer of the option pays a premium. The seller of the option receives the premium.
To translate this into much simpler terms, let’s say you want to buy a house and find a seller.
You ask the seller if he can issue you an option that expires in 12 months and gives you the right to buy the house for $500,000. He will also receive a premium for this option, which equals $10,000.
If he agrees, you have the right to buy the house for $500,000 anytime in those twelve months, and you don’t need to care about housing market price fluctuations.
Let’s say the twelve months passed, and the current price of the house is only $450,000.
In this case, you are obviously not going to buy the house for 500k, so you will not exercise your right to buy it.
But you lost the $10,000 premium, which was the risk you put up.
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